Prepared remarks
Greetings, and welcome to the Fortune Brands Innovations Second Quarter 2026 Earnings Call. Please note, this conference is being recorded. I will now turn the conference over to your host, Curt Worthington, Vice President, Finance, and Investor Relations. Thank you. You may begin.
Good afternoon, everyone, and welcome to the Fortune Brands Innovations Second Quarter 2026 Earnings Call. Hopefully, everyone has had a chance to review our earnings release. The earnings release, earnings presentation, and audio replay of this call can be found on the Investors section of our fbin.com website. I want to remind everyone that the forward-looking statements we make on the call today, either in our prepared remarks or in the associated question-and-answer session, are based on current expectations and market outlook and are subject to certain risks and uncertainties that may cause actual results to differ materially from those currently anticipated. These risks are detailed in our various filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, except as required by law. Any references to operating profit or margin, earnings per share, or free cash flow on today's call will focus on our results on a before charges and gains basis unless otherwise specified. Please visit our website for our reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures. With me on the call today are Jesse Singh, our new Chief Executive Officer; Dave Barry, our Chief Operating Officer; and Ashley George, our Interim Chief Financial Officer. Following our prepared remarks, we have allowed time to address questions. With that, I will turn the call over to Jesse. Jesse?
Thank you, Curt, and good afternoon, everyone. I'm honored and energized to join Fortune Brands Innovations as Chief Executive Officer. Many thanks to the Board for its confidence and to Dave and the leadership team for the decisive actions they've taken over the past two quarters. I'd also like to thank the Fortune Brands team for their hard work through a period of change. I have been here a month, and what I have seen so far has made me even more excited about the long-term opportunity to accelerate growth and expand margins. We have truly exceptional brands, talented people, and decades of strong customer relationships, and our results over the last few years have lagged our potential. We have great core businesses, including Moen, Therma-Tru, and Master Lock. We also have two relevant adjacencies that have become core to the company in our Moen Flo and our Yale connected locks business. We believe we have clear opportunities to expand our position and grow the market in each of these opportunities. We must continue to invest and expand in our core while nurturing our adjacencies. We also have very good people who want to do the right thing, but we, as management, have created conflicting priorities for our team members. Too much of our focus went to internal and corporate distractions and not enough to our customers. Our customers should be the center of everything we do. Our intent is to get back to basics: better service, better products, and a simpler, more customer-focused organization. Ultimately, this should lead to a more efficient organization with better execution. As part of this, we must address underperformance in parts of our core. Our water business, for example, has a strong position in the market but has lagged recently. This is driven by several factors, including service and supply chain challenges. We see opportunities in each of our businesses to improve the customer experience and to drive more focused innovation. Our doors business has an opportunity to drive incremental material conversion to our more resilient products. Our security business has an opportunity to expand into additional categories, and we see opportunity for secular growth in our connected businesses. We are developing plans to address our gaps and realize these opportunities. These plans may require incremental investments and resources to improve our service levels and to accelerate our new product development. We believe these actions will yield better long-term opportunity, growth, and profitability. As part of our increased focus on the business, we intend to streamline our corporate cost structure and shift more resources to our customer-facing businesses. There is real work underway, starting with the previously announced $70 million cost program and a detailed review of the portfolio to better align our resources with our core brands. We will continue to evaluate additional actions as needed to create a higher-performing business. By the end of the year, we intend to have the business realigned against these priorities. We will lay out more specifics on our plans over the next quarter or two, and you should expect to see progress against them during 2027. For the third quarter and the balance of the year, we are assuming a similar operating environment and commercial performance to what Dave and Ashley outlined last quarter. Our updated 2026 guidance is an acknowledgment that we may need to make investments in the company to enhance execution and drive long-term value creation and growth. While it will take time, I am confident that we can build a stronger company that will deliver improved results and shareholder value. We are taking the steps to ensure long-term growth and margin expansion. With that, let me turn it over to Dave.
Thanks, Jesse, and welcome. I'm looking forward to working together to improve execution and operational discipline in the company. As Jesse laid out his near-term priorities, my focus today is the specific actions to help us realize these objectives. As Jesse noted, we are investing more aggressively in the near term to enhance execution and service, supported in part by the anticipated net tariff refund we recognized in the second quarter. On our last call, we laid out our near-term priorities to improve performance and committed to taking decisive actions to achieve those priorities. On today's call, I'll provide an update on the actions we've taken as well as share additional color on the specific steps that are underway. These are aligned to the priorities Jesse described: execution, including improving the customer experience and accelerating new product development, cost structure, and portfolio. Starting with execution. There are still areas of underperformance that are impacting results, and we will continue to invest in improving our execution while working to streamline our business. For example, last quarter, I described our efforts to reinvigorate our new product pipeline. These efforts remain underway, and we continue to build momentum into 2027. I'll point to two recent launches as indicators of our progress, Moen's SwivelControl faucet and Master Lock's Elite padlock. The recently launched SwivelControl kitchen faucet is engineered to lock in place, providing better directional control, hands-free operation, and automatic redocking. In conjunction with this rollout, we also launched a Retrofit Wand that allows existing Moen faucets to be equipped with a SwivelControl feature. We are excited about these new introductions and initial response from consumers and our channel partners has been positive. On the security side, the Master Lock Elite padlock brings meaningful innovation to consumers and pros, including improved security features and enhanced materials. The lock attributes address the number one concern of consumers, vulnerability to forced entry. The product so far is exceeding our sales expectations, and we believe it will continue to gain placement across channels through the balance of the year. As I also noted last quarter, our sales and operations planning process has not kept pace with the needs of the business and our customers, which has contributed to service gaps. While we work to implement sustainable fixes, we are spending incrementally to ensure service targets are met. This performance is felt most acutely in water as our service challenges and related investments impacted top and bottom line results in the quarter. While we are making progress in improving our capabilities, we are not where we need to be, and we are prioritizing investments in our operations to improve service levels and accelerate new product development. On the first quarter call, I spoke about optimizing our cost structure to enhance our business unit-led organization and simplifying our structure. During the quarter, we began the process of moving our brand, marketing, and advertising teams back into the business units. Over the past several years, we have centralized these capabilities, which created distance from our business unit teams, resulting in unnecessary cost and slowed execution. Bringing these functions back into the business units puts brand and commercial decisions closer to the customer, removes layers, and accelerates decision-making. In addition, work is underway to reduce corporate costs, and we have confidence in achieving the previously discussed annualized run rate savings target of approximately $70 million by the first quarter of 2027, with $15 million landing in 2026. Further, we are actively exploring all aspects of our cost structure, and we anticipate ongoing efforts to better align our structure to business results. Lastly, we also highlighted the portfolio as an area of opportunity and our strategic review of Fiberon is underway, following through on the commitment we made last quarter to allocate capital and resources to our highest return opportunities. This is a deliberate step to concentrate investment and management attention on our core brands where we have a clear right to win. We continue to evaluate select portions of our portfolio to drive additional improvements. Turning to the market. Within repair and remodel, we are seeing resilience in certain areas, particularly in luxury categories where the projects are less discretionary, even as consumers remain cautious overall. We continue to expect the R&R end market to be down low single digits for the year. Within single-family new construction, the spring selling season was relatively soft. As we discussed last quarter, our guidance does not contemplate a recovery in single-family new construction in 2026. We still expect this end market to be down mid-single digits for the year. Looking at input costs, inflation continues to accelerate, especially oil, derivatives, and freight. We are monitoring the geopolitical backdrop, including potential outcomes that could ease energy and freight pressure and reduce input cost volatility. Given the uncertainty, our guidance does not assume any relief in commodity inflation before year-end. Additionally, we recognized a benefit from tariff refunds in the quarter. We have called out the net tariff benefit in our consolidated and segment financial results to allow investors to focus on the underlying performance of the business. We expect to use this benefit to invest in our business, including to support service, accelerate new product development, and increase brand awareness with consumers. Looking ahead, IEPA and expiring Section 122 tariffs have been replaced in kind by a combination of Section 232 and Section 301 tariffs. So our overall ongoing tariff exposure remains largely unchanged. With that, I will now turn the call over to Ashley.
Thank you, Dave. As a reminder, my comments will focus on results before charges and gains, unless otherwise noted, and comparisons will be made against the prior year. Before I cover consolidated and segment results, I want to walk through the tariff refunds that we recognized in the quarter and the impact these had on our reported results. Our presentation provides a breakdown of the gross and net impact of anticipated tariff refunds on reported operating income and EPS for the second quarter and full year 2026. During the second quarter, we recognized $122 million in gross tariff refunds. Of this amount, $104 million was recognized as reduction in cost of goods during the second quarter. Net of directly attributable variable compensation expense, this translated to $81 million of operating income, 700 basis points of operating margin and $0.52 of EPS in the quarter. The remaining $18 million of gross refunds was recognized as a reduction in inventory, which will flow through our P&L in the second half. We expect this to be fully offset by the remaining portion of the directly attributable variable compensation expense. Given the uncertainty regarding the amount and timing of any additional tariff refunds, we are not forecasting an incremental net benefit in the second half. As the situation evolves, we will update our guidance accordingly. In the second quarter, we had a cash inflow of $9 million from tariff refunds. And through July 31, we have collected approximately $56 million of gross proceeds. Although we do not have specific guidance on the timing of the remaining refunds, we expect to receive the majority before year-end 2026. Now turning to our consolidated results for the quarter. Total company sales were $1.2 billion, down 4%. The decline in sales was primarily driven by our Water segment, partially offset by areas of growth in Outdoors & Security. Consolidated operating income for the quarter was $236 million, up 18.4%, with margin of 20.4%, up 390 basis points. Second quarter EPS was $1.35. Both operating income and EPS benefited from anticipated net tariff refunds. Excluding this benefit, our second quarter results were in line with expectations. Turning to our segment results. Sales for Water were $605 million, down 6.5%. Excluding China, sales were down 5.4%. Sales were impacted by service level challenges, the carryover of discrete share losses from the first half of 2025, and softness in new construction-related demand in our wholesale channel. These were partially offset by continued growth in the e-commerce channel. Water's operating income was $179 million, up 7.9% with margin of 29.5%, up 390 basis points. Operating income reflects a $66 million benefit from anticipated net tariff refunds, equating to 1,090 basis points of margin. Excluding this benefit, the underlying margin decline was driven by unfavorable price/cost, volume deleverage, and higher cost to serve our customers. In Outdoors, sales for the quarter were $365 million, down 3.8%. Excluding Fiberon, sales were down 1.5%, driven by softer new construction-related demand in the wholesale channel, partially offset by growth in retail and positive year-over-year pricing. In addition, Larson performed well as the NIO reset continued to gain momentum. Outdoor operating income was $56 million, up 14.2%, with operating margin of 15.2%, up 240 basis points, reflecting the inclusion of $5 million of anticipated net tariff refunds and improved operating performance. This was partially offset by lower volume and higher tariff, commodity, and freight costs, particularly for Larson. Anticipated net tariff refunds benefited operating margin by 130 basis points in the quarter. Turning to Security. Sales for the quarter were $184 million, up 3.8%, with growth in the commercial, retail, and e-commerce channels. As we highlighted last quarter, we launched a number of new products across Yale and Master Lock, along with the Master Lock retail packaging refresh during the second quarter. Early feedback has been positive, and we estimate that new products contributed almost 200 basis points to sales growth in the quarter. We expect these initiatives to continue to benefit the back half of the year. Security's operating income was $50 million, up 88.2% with operating margin of 26.8%, up 1,200 basis points, reflecting the inclusion of $19 million of anticipated net tariff refunds and improved operating performance, partially offset by higher tariff, commodity, and freight costs. Anticipated net tariff refunds benefited operating margin by 1,030 basis points in the quarter. Turning to the balance sheet and cash flow. Free cash flow for the quarter was $179 million compared to $119 million last year, primarily reflecting a reduction in inventory during the second quarter. We ended the quarter with net debt of approximately $2.3 billion and net debt-to-EBITDA of 2.7x. We are working to reduce leverage below 2.5x through a reduction in debt levels funded through free cash flow generation. On capital allocation, our overarching goal is to maximize free cash flow. From that, we are prioritizing reinvestment in the business to reinvigorate our product pipeline, enhance execution, and ultimately drive growth, after which we will look to return capital to our shareholders. As we focus on improving our performance, we plan to prioritize organic investment over M&A while balancing our share repurchases with achieving our near-term leverage target of 2.5x. Turning to guidance. Our operating environment and commercial performance are largely consistent with what we outlined on our last call. As a result, our net sales guidance of down low-single digits is unchanged. However, we now expect to be slightly below the midpoint of that range as the previously mentioned execution challenges will continue to weigh on volumes and limit the improvement we originally expected in the second half. We are updating our full year EPS guidance to a range of $3.22 to $3.52, which includes a benefit of $0.52 from anticipated net tariff refunds. If you exclude this benefit, it implies full year EPS of $2.70 to $3.00, reflecting the investments we expect to make to improve service levels, accelerate new product development, and enhance execution, coupled with slightly lower sales growth. Our full year free cash flow guidance incorporates net cash proceeds of $56 million from the tariff refunds received to-date, partially offset by the reduction in our forecasted operating income in the second half of the year. For the second half, we expect a modest improvement in net sales relative to the first half, but still down year-over-year, driven by more favorable retail comps in water and new product launches in security. On a year-over-year basis, we expect price/cost to be unfavorable in the third quarter and favorable in the fourth quarter. At the midpoint of our guidance range, we expect second half margins to be up approximately 100 basis points versus the first half. Looking at the third quarter, we expect net sales to be down between 1% and 2% and EPS to be between $0.72 and $0.76, which assumes operating margin between 12.5% and 13%. As Jesse and Dave shared, we still have work to do to improve our execution, optimize our cost structure and realign our business. While these actions will take time, we are confident that with the right focus and investment, we can set the company up for a stronger future. With that, I'll turn the call back to Curt.
Thanks, Ashley. That concludes our prepared remarks. We will now begin the question-and-answer session. Since there may be a number of you who would like to ask a question, we will ask that you limit your initial question to two and then re-enter the queue to ask additional questions. Operator, can you open up the line? Thank you.
Questions and answers
And our first question will come from Keith Hughes with Truist Securities.
Jesse, a question for you. You've been at the company for about a month now. If you could just talk about after your month there, what do you think the biggest opportunities are at Fortune Brands and flip side, what's some of the biggest challenges you face?
I came into the role assuming that this business had long-term sustainable growth potential and margin capacity. Coming in after the first month, if anything, I'm even more optimistic about that long-term opportunity. If you think about the strength that we have established over the years, we've got a diverse portfolio. We play in three really good markets. We've already made the investments necessary in our adjacency in the connected space. I've been pleasantly surprised with the talent that we have. I've been impressed that despite a bit of change in the organization, including at the top, the team over the last few months has really been focused on building out new product pipelines. The brands continue to be really relevant in the market. And I think one of the other things that, as you know from my previous company, you look for is whether there's a growth opportunity that can come from expanding from where you are, whether that be some kind of a material conversion or really expanding the market into other categories. I've been pleasantly surprised in the early discussions across all of our businesses that those kinds of opportunities exist. Obviously, in a business like Therma-Tru, there's more material conversion opportunity. In Connected Home, there continues to be opportunity where that market is just growing. And in our core Water business, there also continues to be opportunity to really expand the pie. In terms of some of the challenges, I think we touched upon them on the call. We need to get back to making sure that we deliver a really good service level to our core. There's been good progress there. We're going to have to continue down that journey. I also think we've just been way too complex, and I highlighted that in my comments on the call. We've had a complex organization that the team has had to work through. I think as we simplify that and bring the discussion down to how we continue to grow and execute in each of these important businesses, I think we'll start seeing the results.
Okay. Great. One other question. I was interested in Dave's comments of you're moving the marketing and advertising, et cetera, back into the field, if you will, which is great news. How long will you take? Will you be able to get that done by the end of the year, I guess, is really the question?
Yes. We've taken, and I'm glad you pointed out Dave's comments. I think Dave did a terrific job in the short time that he had to start to move back in that direction. I think we're looking at ways to align the business to really give our businesses a chance to aggressively execute. I would expect that we'll continue to refine that, and we'll make really good progress in the months to come. We would expect to be in a really good position by the end of the year.
And Keith, I would add, if you think about it, we talked about it last quarter: fundamentally, it's about getting these resources of ours closer to the business, to increase execution and efficiency and really become more customer-focused. As Jesse called out, we have great people who are in roles now. We have critical talent. It's really getting those people set up for success and getting our business set up for success by putting them in the right spot in the organization. That work is underway with pace right now.
And our next question will come from Matthew Bouley with Barclays.
So just one on sort of how you're thinking about the cost outlook here. So if I'm hearing everything correctly, you sort of had this, I guess, fortuitous opportunity to take these tariff refunds and you needed to be reinvesting and you're using that to reinvest here. It sounds like maybe there's some front-loading. But at the same time, you see kind of a longer-term opportunity to really streamline the corporate structure of the business. So my question is basically timing and magnitude there. How should we think about what needs to be reinvested into the business? And then at what point could we really begin to see the sort of fruits of those efforts? And how do you think about that ongoing cost structure of the business?
I appreciate the question, and it is certainly the right question for the long term. It is too early to give you a precise cadence of that combination of reallocating resources and the overall ramifications. I think with our current guidance, there's an acknowledgment that that balancing act may require some investment before the costs are fully realigned. We'd be hopeful that we could make progress against that balance sometime during 2027. For the long term, there's certainly opportunity to increase resourcing in the business while we are driving SG&A efficiency.
And Matt, maybe I'd add the areas where we're investing: we would have addressed those areas regardless of the tariff refund. They're core to protecting the business, the revenue and the future of the business. With Jesse on board, we're using it as an opportunity to be more aggressive and accelerate those investments here in the near term, so that we set ourselves up for success in 2027.
Got you. Okay. Yes. No, got you loud and clear and appreciated that a lot of this is still kind of to be determined. So then maybe second one, just kind of jumping down into the model and the numbers on the Water business. Appreciating there's a lot of moving pieces with the tariff refund there in terms of the margin. Obviously, we saw your peer report last week. Maybe you can kind of break out sort of underlying market performance in the Water industry, how volumes and price are tracking and sort of within the guide, how you're expecting all of that, both top line and the margin cadence in the second half to play out?
Let me jump in with some of our numbers and drivers for Water in the quarter, and then I'll have Dave add some color. If you look at this business, clearly not performing where we want it to, sales down 5.4% in the quarter, excluding China. That is price up low-single digits, volume down high-single digits. I think about drivers in the quarter as two primary drivers, both driving about half of that net sales decline. The first one is the carryover from discrete share loss in the first half of last year that we've talked about. And then the second driver were the service challenges in the quarter that we talked about. There are some other puts and takes, but I think about those as the two primary drivers for Q2. Probably worth saying as well that our luxury segment continues to outperform. Our House of Rohl sales performance was better than the Moen business in the quarter. Let me flip to operating margin, and then we can add some color. But from a margin standpoint, if you take out the impact of tariff refunds and do the math, you get operating margin down 700 basis points versus prior year. Three big drivers. About half of that is coming from price/cost, which was as we expected in the quarter. You've got another roughly 200 basis points coming from some of the service challenges, incremental costs that we incurred to serve our customers in the quarter. And then the remaining really comes from volume deleverage. So if you back out the service challenge impact of 200 basis points in the quarter, you get to something that was in line with our expectations coming out of Q1.
And I think that's a critical point, Matt. If we step back and just look at the Water business, commercially largely performing in line with our expectations a quarter ago. As Ashley alluded to, the top line was impacted, call it, 2.5 percentage points from a sales perspective from service and inability to fulfill the demand. That's one of the areas we're focused on investing. We will continue to spend on premium freight. We'll continue to spend in our DCs. We will look at sourcing, even if it's from a higher-cost supplier that can be more delivery focused and get our products more consistently. Looking at the margin, what really was different was that premium cost to serve from a quarter ago. We'll continue to spend there. That will be investments through the second half. If you think about where Water margins could go from here, there are still pretty significant price/cost headwinds in the third quarter. They start to ease a bit from the 380 basis points, but they're still significant. That starts to turn more favorable in the fourth quarter. As we sustainably solve our demand planning and service challenges, that can become a tailwind as you move into 2027. So I do think the next couple of quarters probably represent more of a trough for Water margins and then you'll start to see them build back as we move into next year.
And we'll go next to Susan Maklari with Goldman Sachs.
My first question is, at a higher level, can you help us bridge the revised earnings guide of $2.70 to $3.00 relative to the prior guide of $3.00 to $3.30. Can you just kind of walk through the puts and takes there that we should be thinking about?
At a high level, and I'll let Dave provide a bit more color, from a commercial standpoint, the business is operating similar to what was discussed last quarter. I think there are two components to the adjustment. Number one: there's an acknowledgment that incremental expense would provide incrementally better service, which we think is the right thing for our customers. The second component is we are starting the journey of accelerating certain investments that we believe will start to put the business back on a growth trajectory. The most obvious example is our product portfolio: we have a pretty good and accelerating portfolio of potential new products. For example, in Security we launched a more premium lock recently that's doing well. We see opportunity to continue to expand that portfolio and other products like that. We want to find ways to accelerate those types of products. Similarly, we see material conversion opportunity in our Doors business. We want to make sure we take the steps to accelerate those types of products. There will also be some incremental additional investments related to growth.
And I would add, just to put some numbers behind it, if you think about the $0.30 drop in EPS at the midpoint, I think of it as about $0.20 or so of investment that Jesse outlined and then, call it, $0.10 or so of volume, but really volume directly attributable to service constraints. Another good example where we're having some strong success is with Yale in multi-family: we're choosing to really prioritize that volume at the expense of maybe running an incremental promotion that might overwhelm some of our service. It's really continuing to focus on where we can serve, where we are winning, how we prioritize that volume, and dialing back some of the extra things in the near term while we get everything more sustainable going forward.
Okay. That's very helpful color. And then maybe turning to the various priorities that you outlined — the execution, investing in service, optimizing the cost structure, reviewing the portfolio. Can you give us some sense of which of those we should expect to come through in the near term, maybe within the next couple of quarters, the next year versus are there some of those that will be a bit longer in nature and take more time to work through and come through to the results?
At a high level, think of customer experience, improvement of execution, realignment of the organization, new product growth, and an increase of investment in our core. We're taking action on all of those things right now. We would hope to see progress from those actions during 2027. Growth tends to be a longer cycle activity, especially new product growth, which may take longer. But as we look to streamline our execution, improve our service, and simplify our organization, you're going to start to see benefits early into 2027.
As we said in the prepared remarks, we're on track for delivering the $70 million cost out separate from the investments that we're making in the near term to continue to improve the performance of the business. To Jesse's point on new products, we're rebuilding that pipeline and trying to pull things through faster. But that could be a two-, three-, four-quarter lag because by the time you launch a product, you get placement, the shelf resets, it can take that long. So new products may be more impactful as you move into the second half of next year, even though we're starting to see some wins now. We should have the initial wave of cost out behind us in the first quarter.
And we'll hear next from Mike Dahl with RBC Capital Markets.
So I also wanted to follow up on kind of the investment dynamic just to make sure we have a clear picture of it. You've outlined a couple of things kind of high level in terms of outlooks. It sounds like a lot of this is in Water, but then there's some new product-oriented dynamics. Can you just give us a little bit more of a detailed kind of bridge on or quantification of where these investments are sitting in terms of both, I guess, by category or by segment, just to help us understand that second half dynamic a little bit more?
I contextualize it based on performance. Outdoors & Security are largely performing as expected, and the opportunity there is to invest to accelerate performance. You'll see new product investment going into Outdoors & Security. You'll see commercialization investment in both of those businesses to accelerate the new products that we've launched. We have a Master Lock brand campaign that's performing really well, so we'll continue to invest behind that. On the Water side, it's the biggest piece of our business and it's performing below expectations at the moment. So the bulk of the investment will be directed toward Water, especially on the service side as we look to continue to spend to service our customers.
Let me provide a bit of context on how we arrived at some of these service issues. We made some systems changes and some organizational changes. For the right reasons, we also made some supply chain changes as our supply chain was under stress during the initial and multiple rounds of tariffs. The outcome was some disruption in our supply chain and therefore some disruption in our service. A lot of what we're talking about is getting back to a stable supply chain, getting back to stable S&OP processes, reverting where appropriate to core systems that supported consistent delivery, and getting back to a baseline of performance. We're addressing that issue; this is a well-known type of problem and the plan is to bring the organization back to stability after a year of changes.
From the CapEx point of view, if you think about our CapEx, we're roughly 1% of sales maintenance CapEx and the balance for growth, new products, and cost out. In the guide, the CapEx guide of $110 million to $125 million is lower than it's been in years past, but we had some more capacity investments in years past and now feel like we're well-positioned to absorb incremental volume in future years.
And our next question will come from John Lovallo with UBS.
The third quarter operating margin of 12.5% to 13%, that's inclusive of the $18 million of gross refunds in inventory that's coming through COGS in the quarter, correct? And if so, how should we sort of think about margin pressure across segments?
Let me start. In Q3, it does include the incremental refund coming off the balance sheet, but important to note that will be offset with the directly attributable variable comp and some of that will hit in Q3 and Q4. That will essentially offset that net benefit in the second half. Q3 margins, if you think about it sequentially off of Q2, you'll see some favorability coming from price/cost as that starts to improve sequentially in Q3, although we don't see the year-on-year improvement until Q4. But then that is offset by both volume leverage and SG&A from the investments to drive execution we've been talking about. So net down sequentially: price/cost favorable, investments unfavorable.
The only thing I'd add is that prior year there was a benefit from variable comp unwind that was sizable in the quarter last year — about $25 million or 270 basis points. So we're comping that benefit from last year. Otherwise, I agree with what Ashley said: price/cost is a little bit better sequentially, it's still unfavorable year-over-year, and then you have some volume deleverage on the margin.
Okay. Got you. Okay. So then SG&A in the quarter, dollars were up about 4% year-over-year on like a 4% decline in revenue. And I think as a percentage of sales, SG&A was up like 230 basis points. I thought there may have been some incentive comp in that, but it appears like there may not have been. So what sort of drove that outside of a little bit of deleverage?
There is incentive comp. And just to clarify, we were talking earlier about how the tariff-related directly attributable incentive comp impacted SG&A.
Yes.
And we'll go next to Phil Ng with Jefferies.
In your past role, I would say you were super collaborative with the channel. So what's the early feedback? What are you hearing from your channel partners? Are there areas where perhaps you may realign who you work with, particularly on the plumbing side where you're oversupplied, undersupplied, areas where you think you could fill a void perhaps where you're underpenetrated like e-commerce? Just give us an early read in terms of what you're hearing and opportunities on the channel side of things.
I appreciate the question, Phil. Coming into this role, I've been very pleased that we've got brands that matter and brands that are relevant to each of our channel partners. That's a good place to start. In each of our businesses, there's opportunity for us in all channels. There are certainly some channels where we are underpenetrated and where better execution and correct products will give us growth. It varies by part of our portfolio. Macro-level, in a couple of businesses, like Water and Doors, we have a great position with new construction, which is important for the long term. But in both those businesses, we are under-indexed in the repair and remodel-oriented side of the business. R&R has been more stable; it's broad and complex with multiple channels and customer sets. There's an opportunity for both those businesses to continue to expand into that part of the housing sector.
Okay. That's helpful. Perhaps a question for Ashley. In the press release, you guys provided some color in terms of Outdoor sales and how that would look like without Fiberon. Not going too deep, any color when we think about how that portfolio could look like over time with some of the cost-out actions in that same format with or without some of those dynamics, how should we think about the opportunity for that margin profile opportunity for Outdoors going forward?
This is Dave. It's hard to get into details when we're in an active strategic review of the business. But for Doors, we feel really good about the strength we have within Therma-Tru. It's a material conversion story that hasn't fully played out. Doors are probably about 55% converted right now away from wood and steel, so we see secular growth opportunities in Therma-Tru and we are the leader in that space. Larson's reset at our retail partner continues to go really well; we continue to work through that product portfolio, and we see Larson growing POS, growing share, and performing well. It's a good example of what we can do when we get new product commercialization right. We're happy with the Doors business, and we'll continue to move with pace on the strategic review of Fiberon.
And moving next to Trevor Allinson with Wolfe Research.
First one on the overall portfolio and going back to the Fiberon strategic review. What's the timeline for completion there? And then as we think about the portfolio more generally, how should we think about other parts of that business or other parts of your business overall? Could there be other companies that you look at as maybe not being core for you guys moving forward?
Trevor, I'll take Fiberon and let Jesse comment on the portfolio. We've retained advisers, and I'm pleased with the progress we're making against identifying the appropriate outcome, which for us is looking to maximize value for our shareholders and also set the business up for success with our customers and our employees. I can't commit to a specific timeline on the call, but we're moving with pace and pleased with where we are.
On the overall portfolio, think of it at a granular level where we want to be in a really good position to win and continue to expand. We'll review certain product lines or subsegments within the aggregate portfolio to see if there are optimizations. In general, the three core pillars plus the adjacent connected pillar are areas where we feel good about our ability to win and expand, but there may be tweaks within those pillars to optimize. It's early, and we'll keep you updated.
Okay. I appreciate all that color. And then second one would be on your inflation expectations across the business in 2026, specifically in Water, given the move in copper and zinc prices year-to-date. How should we think about the inflation across those businesses and across the entire year? And perhaps some commentary on exit rate inflation.
If we look at inflation for the year, it's pretty consistent with what we've talked about previously. We have about $100 million year-on-year increase in tariffs hitting the P&L in the year. Remember, a larger portion of that hit in the first half. We are increasing our commodity estimate from $80 million incremental to $90 million incremental — a $10 million increase in commodity and freight inflation driven across brass, copper, aluminum, and freight. As we assess 2027 and where we're coming out of this year, we're in early planning phases, so it's too early to comment on specific 2027 numbers. The cadence usually gives us time in planning to assess those commodity increases against pricing in the market, and we'll do that holistically as part of our 2027 planning.
And our next question will come from Stephen Kim with Evercore ISI.
My first question relates to the incremental investments. If my math is right, it seems like you're talking about, call it, $45 million to $50 million of incremental investments this year. I think you said about two-thirds of that's going to be due to addressing service issues and hopefully getting some volume from that, and about one-third would be from initiatives like new products. First question: where do these investments hit the P&L? And secondly, can you give us an understanding as to how you're going to boost near-term product launch productivity through incremental investments? Is this basically just marketing expense? Is this going to be some sort of increased incentives of some kind? Just give us a sense for how those dollars are going to be allocated.
I'm happy to start. Steve, to clarify, on the investment side we talked about roughly $0.20 of EPS, so call it $30 million or so. Predominantly that will hit through OpEx, mostly in SG&A as we move through the balance of the year, and maybe a bit in COGS if we move some sourcing around. On the new product side, things we can do include commercialization — as you launch products, make sure we're supporting them in the marketplace. There's also opportunity to co-invest with suppliers to develop technologies faster. One area of opportunity to bring products to market faster is to work more closely with our sophisticated supply base to do that. We'll also add incremental resources where the team needs them to pull projects in faster. It's the focus we've talked about now for a couple of quarters to get the new product development engine going; initial results are pleasing, but there's more work ahead.
Got you. That's helpful. When you talk about service a number of times, it seemed like that was the main difference from your expectations in your Water performance. Can you talk a bit more specifically about what the issue is there? It sounds to me like it's not purely a suboptimal geographic supply chain change but maybe more a systems or software issue. Can you give us color there? Was there a discrete event that hit this particular quarter? Because service levels is something you were focused on earlier; I would have expected that you would have accounted for something in Q2 already. If you could provide color, that would be helpful.
I'll start. In terms of discrete drivers, think of it as expedited freight and the cost of expediting product to make sure we sustain delivery to our channel partners. We are working through that. We have a number of SKUs across different product categories and different reasons for the disruption. In some cases, it was an outcome of a change of a source of supply where the receiving supplier couldn't ramp up fast enough. In other cases, it was, as you suggested, systemic issues. The organization has gone through a lot of change in the last six to twelve months. As part of that change, we made some alterations to the systems we use to conduct our S&OP. The new process and systems did not deliver the required levels of inventory to service our customers. Simply put, we had a few misses. We're resetting back to the processes that allowed us to consistently deliver for years, and we're returning the organization to stability. The intent of the changes was positive — to have higher service at lower inventory — and that did not work out. We're addressing it methodically.
And this now concludes our question-and-answer session. I would like to turn the floor back over to Jesse Singh for closing comments.
Thank you all for engaging with us tonight. We are really excited about the opportunity ahead. As I mentioned earlier, we are confident that we've got a terrific opportunity to start to accelerate this business. It will require some additional investment, as we've discussed. I'm confident that we've got the right team to continue to progress this. What we talked about today is the first step in that direction. I look forward to chatting with many of you in subsequent events. Thanks, and have a great evening.
Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may disconnect your lines, and have a wonderful day.