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Edited Transcript of DOOR earnings conference call or presentation 5-Nov-19 2:00pm GMT

Q3 2019 Masonite International Corp Earnings Call

TAMPA Nov 10, 2019 (Thomson StreetEvents) -- Edited Transcript of Masonite International Corp earnings conference call or presentation Tuesday, November 5, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Howard Carl Heckes

Masonite International Corporation - President, CEO & Director

* James A. Hair

Masonite International Corporation - President of Global Residential Business

* Joanne Freiberger

Masonite International Corporation - VP & Treasurer

* Russell T. Tiejema

Masonite International Corporation - Executive VP & CFO

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Conference Call Participants

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* Elad Elie Hillman

JP Morgan Chase & Co, Research Division - Analyst

* Jay McCanless

Wedbush Securities Inc., Research Division - SVP of Equity Research

* John Allen Baugh

Stifel, Nicolaus & Company, Incorporated, Research Division - MD

* Kevin William Hocevar

Northcoast Research Partners, LLC - VP & Equity Research Analyst

* Michael Glaser Dahl

RBC Capital Markets, Research Division - MD of U.S. Homebuilders & Building Products

* Michael Robert Wood

Nomura Securities Co. Ltd., Research Division - Research Analyst

* Noah Christopher Merkousko

Stephens Inc., Research Division - Research Associate

* Reuben Garner

Seaport Global Securities LLC, Research Division - Associate Analyst

* Steven Ramsey

Thompson Research Group, LLC - Senior Equity Research Analyst

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Presentation

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Operator [1]

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Welcome to Masonite's Third Quarter 2019 Earnings Conference Call. (Operator Instructions) Please note that this conference call is being recorded.

I would now like to turn the call over to Joanne Freiberger, Vice President and Treasurer.

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Joanne Freiberger, Masonite International Corporation - VP & Treasurer [2]

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Thank you, Rob, and good morning, everyone. We appreciate you joining us today. With me on the call today are Howard Heckes, Masonite's President and Chief Executive Officer; and Russ Tiejema, Masonite's Executive Vice President and Chief Financial Officer. We also have Tony here President of Global Residential, joining us for Q&A session. We issued a press release and WebEx presentation late yesterday afternoon sharing our third quarter 2019 results. These documents are available on our website at masonite.com.

Before we begin, I would like to remind you that this call will include forward-looking statements. Each forward-looking statements contained in this call is subject to risks and uncertainties that could cause material results -- could cause actual results to differ materially from those projected in such statements. Additional information regarding these factors appears in the section entitled, forward-looking statements in the press release we issued yesterday.

More information about risks can be found under the heading Risk Factors in Masonite's most recently filed Annual Report on Form 10-K and our Form 10-Q anticipated to be filed with the SEC later today. Our SEC filings are available at sec.gov and on our website at masonite.com.

The forward-looking statements in this call speak only as of today, and we undertake no obligation to update or revise any of these statements. Our earnings released in today's discussion includes certain non-GAAP financial measures. Please refer to the reconciliations which are in the press release and the appendix of the webcast presentation.

Our agenda for today's call includes a business overview from Howard followed by a review of the third quarter financial results from Ross and closing remarks from Howard with a question and answer session.

And with that, let me turn the call over to Howard.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [3]

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Thanks, Joanne. Good morning and welcome everyone. As Joanne mentioned late yesterday, we released our third quarter 2019 financial results. I am pleased that we delivered a third consecutive quarter of both year-on-year adjusted EBITDA growth, and adjusted EBITDA margin expansion with all 3 business segments delivering higher margins than the prior year. At a consolidated level, this was primarily driven by higher average unit price or AUP along with continued operational productivity improvements, which were partially offset by the impact of lower volume and higher SG&A.

Net sales decreased approximately 1% in the third quarter as compared to the prior year. Despite continued strength in AUP across all business segments, the impact of declines from lower base volumes, foreign exchange headwinds, and a decrease in the sale of components and other products more than offset the growth. Base volume declines were due to continued softness in end-market demand, largely in line with our expectations. Excluding the impact of FX, third quarter net sales were flat with the comparable period last year. As mentioned last quarter, in July, we successfully completed a $500 million bond issuance to refinance our existing notes that were due in 2023. We retired those notes in the third quarter and as a result, we incurred a debt extinguishment costs of roughly $11 million after tax. Those costs were the primary driver of our year-on-year declines in both net income and diluted earnings per share. For the purpose of adjusted EPS, we excluded those charges. We're very pleased with this transaction. It was a great opportunity to further extend our debt maturities at a reduced coupon rate with no impact to our overall leverage.

Moving to the right of the slide, a brief overview of our business and operations. As I mentioned on the second quarter call and I'll reiterate it now, our operations group is doing a great job of continuing to drive the MVantage operating system across Masonite. This quarter, we completed another plant transformation, initiated one more and continued training throughout the organization. I'll get into more specifics on the MVantage operating system year-on-year metrics in a couple of slides. We believe that execution and dedication to our MVantage operating system is resulting in factory productivity improvements, which we continue to see read through our financial performance. Not only was third quarter factory productivity able to offset year-on-year inflation for direct labor and overhead, it also offset anticipated new factory start-up costs and discrete manufacturing items in the quarter.

Our footprint and portfolio optimization actions are progressing as planned. Last quarter, we announced the opening of a new interior door plant in Tijuana, Mexico. We utilize the same tools and process of a plant transformation to optimize layout and flow from the start. The facility is ramping up as expected and began shipping initial orders in October.

On Slide 6, we summarize the housing market data for our major geographies. In-line with our expectations, we continue to see relatively soft end-markets across our business segments. While US single-family housing starts and completions are up year-on-year, the growth is at low levels and against relatively easy comps. And while you're hearing homebuilders in the US report order increases, we have yet to see that reflected in demand for our products. Additionally, where US homebuilders are seeing their growth is primarily an entry-level homes likely with fewer doors. While we would expect to see the impact of stronger new home orders begin to flow through our results in upcoming quarters, the mix towards smaller footprint homes would be an offsetting headwind. This dynamic is another reason we continue to stay focused on marginal improvement.

Now let's move to Slide 7, where I'll provide a brief update on those margin improvement initiatives. Again, I'm very pleased with the continued commitment to operational productivity and execution on the MVantage operating system across the organization. The 3 key pillars of advantage our training and standards, which provide a toolset for our employees to drive continuous improvement programs; pit crews, which our performance improvement teams routinely deploy throughout our operations to drive rapid improvement projects in specific areas; and finally plant transformations which are broader improvement events utilizing multiple teams across a single site to evaluate and improve entire value streams. As I mentioned earlier, we completed another plant transformation and initiated one more at our Haleyville, Alabama Facility. This plant transformation is well underway, and we are already seeing improvements. The continuous improvement team along with plant's employees have redesigned the flow and layout of the (inaudible) area. This improvement not only freed up space for additional door assembly, it is also eliminated the need for fork trucks in the (inaudible) area. The move from fork trucks to hand trucks improves plant safety and reduces the need for capital. We continue to complete pit events throughout the organization and have almost doubled the number of Kaizen events, year-to-date. We also have a 44% increase in the number of lean certifications in the third quarter compared to prior year. This increase is relevant because certifications are only given to individual's once they completed a project with measurable savings.

Lastly, we continue to increase the number of employees participating in events. We had over 350 new participants involved in Kaizen events during the third quarter alone. Increasing participation is important as it improves the engagement of our manufacturing employees. As these employees participate in advance and feel ownership over their processes, it instills a productivity mindset.

Moving to the center of the slide, we have a brief update on our footprint optimization initiatives. We are on track with the announced closure of 4 of our North American facilities. We successfully exited the residential door assembly plant in Denmark, South Carolina in April. We are on schedule or slightly ahead of our original target closure dates for the remaining 3 facilities. The stock in California interior door assembly plant, Tampa manufacturing, and Largo Florida facilities are all on track for closure by year-end.

As mentioned, our new Tijuana plant is progressing as planned and began initial shipments in October. We are pleased with the progress there. Between a focus on the MVantage operating system from inception and leveraging Masonite's best practices from our other facilities, we believe the Tijuana facility will be one of our most efficient plants.

Moving to portfolio optimization. Similar to the last quarter, European margins benefited from the divestiture of 2 non-core UK businesses earlier this year. The team continues to make progress on divesting up third, non-core UK business, which we expect to complete in the fourth quarter of 2019. AUP and margins continue to benefit from prior portfolio management. The realignment of our Mexico business with a focus on specialty products has helped increase AUP and shed some margin dilutive business. We believe the capacity previously dedicated to the low margin SKUs, we exited in Mexico is better utilized to service higher AUP business elsewhere in the North American residential segment.

During the third quarter, we communicated to our US and Canada customers, we would be reducing our entry door design offerings by over 30% beginning in the first half of 2020. Reducing existing designs will make room for new more on-trend and differentiated doors. At the same time, this reduction will ease production with little impact on user demand. I continue to be pleased with the organization's solid execution on these key strategic initiatives. We clearly saw the benefit of these margin improvement initiatives in our financial performance during the quarter.

With that, I'll turn the call over to Russ to provide more details on our third quarter financial performance, Russ.

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [4]

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Thanks, Howard, and good morning everyone. Let's move to Slide 9 and a summary of our consolidated financial results for the quarter. We had net sales of $552 million, down 1% versus the third quarter of 2018 or flat year-on-year, excluding foreign exchange. Solid average unit price across our 3 segments contributed growth of 5%, which was offset by a 4% decline in base volumes and a 1% decrease in sales of components and other products. The base volume decline was largely in-line with expectations and attributable to both [continued] softness in our end-markets, primarily from US new housing, and our exit from lower-margin product lines in Mexico earlier this year. We saw another strong quarter of gross profit and gross margin expansion, primarily due to higher AUP and factory productivity, partially offset by the impact of lower volume and higher material costs due to tariffs.

Gross profit was up by over 13% in the third quarter with gross margin expanding 280 basis points versus the prior year to 22.7%. SG&A spending was $13 million higher in the third quarter, primarily driven by higher incentive compensation, as well as additional SG&A costs from acquisitions.

As Howard mentioned, we delivered our third consecutive quarter of adjusted EBITDA growth and adjusted EBITDA margin expansion. Adjusted EBITDA increased by approximately 7% to $76 million, while adjusted EBITDA margin expanded 100 basis points to 13.7%. The bridge on the right hand side of the slide shows the combined benefit of volume mix and price on adjusted EBITDA performance. Commodity inflation coupled with the impact of tariffs was roughly a 3% percent headwind in the quarter. Net inflation remains lower than our original 2019 expectations, due in part to the great work of our global sourcing team. They continued to identify and implement savings projects. As a result, the net impact we saw in our material cost in the quarter was principally tariffs. Factory costs were flat year-on-year with strong factory productivity offsetting not only wage and benefit inflation, but also additional costs related to new factories start-ups and discrete manufacturing items in the quarter. These items total almost $2 million including start-up costs for our Tijuana, Mexico and Verdi, Nevada facilities of approximately $1 million as well as some final cleanup costs related to our Stockton, California cut-stock fire. While cleanup costs are behind us, the start-up cost will continue to the ramp up of the facilities, albeit at diminishing levels. Distribution costs were higher in the quarter primarily due to some previous changes in shipping lanes to service existing retail customers on the West Coast.

Finally, net income for the third quarter was approximately $15 million and diluted earnings per share was $0.59. Diluted EPS was down $0.30 per share, from $0.89 per share in the third quarter of 2018 due to a charge of $12 million after-tax related to debt extinguishment and previously announced restructuring activities. Excluding the impact of those items, our adjusted diluted EPS was $1.08 in the third quarter of 2019 compared to a $1.03 in the comparable period of 2018.

Turning to Slide 10 and our North American residential segment. Net sales were up 2% compared to the prior year, driven by growth of 4% from a AUP and 3% from our BWI acquisition in the fourth quarter of 2018. This was a North American residential segments 11th quarter of consecutive AUP growth supported by both price and mix despite lapping July 2018 price increase. These gains were partially offset by declines of 5% in base volume through the continued softness in our US and Canada wholesale business, and the impact of previously discussed Mexico portfolio actions. While the shedding of this lower business in Mexico is negatively impacted top line performance in the short term, it is margin accretive to the segment and affords us additional capacity in our Monterrey plant to service higher AUP business elsewhere in North America going forward. We continue to see year-on-year declines in retail as well but at more modest levels than in the second quarter and generally in line with point of sale results in the stores that we serve. Despite continued soft end-market conditions, we delivered meaningfully higher adjusted EBITDA and adjusted EBITDA margins in the North American residential segment. Adjusted EBITDA was up 15% in the third quarter compared to the prior year and margins increased 200 basis points. Higher AUP and factory productivity were primary drivers, partially offset by the additional factory cost I noted earlier, all of which impacted the segment. Overall, a very solid quarter for the North American residential business despite soft end-market demand for the time being.

Turning to Slide 11 and our Europe segment. Net sales decreased by approximately 17% year-on-year in the third quarter, driven in large part by 12% decline from our divestiture of non-core UK businesses in the first quarter, as well as a 4% decline in base volumes and a 4% decline due to foreign exchange. The British pound, our largest currency exposure in the segment, was down over 5% versus the US dollar from the comparable period last year. On a bright note, AUP was up 4% year-on-year as a result of both higher price and improved mix, which offset the decline in base volumes that were the result of previously lost share in the builder channel. With the integration of our interior door distribution complete and service at target levels, we believe we are positioned to recover business with our key builder customers and our UK team remains keenly focused in this area. The Europe segment once again delivered strong adjusted EBITDA margin growth, up 230 basis points to 14%. Margin growth was a result of both the divestiture of the non-core businesses, as well as continued strength in our entry door business supporting the repair and remodel market. Lastly, during the quarter, we acquired a small but highly synergistic doorframe business in the Czech Republic. Unlike our competitors in that region, we previously did not have fully integrated frame production. So this was an opportunity to acquire those capabilities at a minimal investment.

Moving to Slide 12 in the architectural segment. Net sales increased by 5% in the third quarter due to growth of 7% from AUP, which benefited from higher pricing on projects quoted beginning in early 2019, as well as favorable mix. This growth was partially offset by a 1% decline in base volume and a 1% decline in the sale of components and other products. Adjusted EBITDA increased 24% year on year and adjusted EBITDA margin expanded 220 basis points to 14.4% in the quarter. We were pleased to again see continued strength in our architectural quick-ship business which caters to custom finishing and machining for commercial customers who value speed of delivery.

Following our acquisition of A&F Wood Products in late 2017, we have prioritized additional strategic investments in people and systems for this line of business and are seeing continued growth as a result. Similarly, we were pleased with the performance of the Graham and Maiman business we acquired in June of last year. Recall that our objective at that time was for the business to reach double-digit EBITDA margins by the second year of ownership. We exited the second quarter this year at that rate, and the business continues to consistently perform at that level.

Slide 13 summarizes our liquidity and cash flow performance for the quarter. Total available liquidity including unrestricted cash and accounts receivable purchase agreement and our undrawn ABL facility was $312 million equal to approximately 14% of our trailing 12 months' net sales as of September 29, 2018. At the end of the third quarter, total debt and net debt to trailing 12 months adjusted EBITDA were 2.8x and 2.4x respectively comfortably within our target of 3x total debt to trailing 12 months of adjusted EBITDA.

Cash flow from operations was $50 million in the quarter, down slightly from $52 million in the third quarter last year due to cash restructuring costs and slightly higher interest payments. Capital expenditures of approximately $18 million were roughly flat year-on-year. Free cash flow conversion was a 120% in the third quarter and stands at 109% through the end of the third quarter with the expectation that full year free cash flow conversion will be in excess of 100% of adjusted net income, consistent with last year.

During the third quarter, we repurchased approximately 195,000 shares under our existing share repurchase program at an average price of $49.76 per share, totaling approximately $10 million in the quarter. This is slightly lower than last quarter due to share price appreciation and the structure of our 10b5-1 program. Since the inception of this program in February 2016, we have repurchased roughly 24% of the shares that were outstanding when we began that program at that time. A quick update on one balance sheet item. In October, we took actions to reduce future pension obligations. We entered into a transaction and transferred approximately $23 million of pension benefit obligation by purchasing an annuity contract with $23 million of pension plan assets. The transfer of these obligations settles future liabilities and reduces risk associated with the US pension plan due to changes of discount rates and return on assets. In the fourth quarter, we expect to recognize a non-cash settlement charge were approximately $6 million associated with this action, which we will exclude from adjusted EPS. On a related note, we mentioned in our press release yesterday, our full year 2019 outlook remains consistent with the update we provided during the second quarter earnings call. When we indicated that we expect full-year net sales growth in the range of flat to up 2%, inclusive of foreign exchange, adjusted EBITDA of $275 million to $295 million, and diluted adjusted EPS of $3.30 to $3.90. We are leaving these range unchanged while acknowledging that based on current demand levels we're seeing for our product, we believe that our full-year results are more likely to be in the lower end of these ranges, then the upper end. That said, there are some recent developments that could result in increased volatility and demand for our products in the fourth quarter. Howard will speak to this in a moment.

Additionally, there are several headwinds anticipated in the fourth quarter that are worth noting since they could moderate year-on-year margin growth, including continued ramp-up costs at our new manufacturing facilities in North America, reductions in incentive compensation accruals in the fourth quarter of 2018 that we would not expect to repeat this year, and the expectation of higher legal costs associated with the previously [disclosed] crop losses.

And with that, I'll turn the call back to Howard for some closing comments.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [5]

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Thanks, Russ. In summary, we're pleased with our third consecutive quarter of year-on-year adjusted EBITDA growth and related margin expansion at a consolidated level, and the performance across our 3 business segments. Solid AUP growth and the outstanding work, the organization is going to drive productivity are making this possible despite the headwinds were facing due to soft end-markets. We continue to see the benefits and the organization's focus on our MVantage operating system. We completed another plant transformation and launched one more during the quarter. In addition to plant transformation on existing plants, we are using the same tools and processes in Tijuana as we try to ensure this facility is as efficient as possible from inception.

We continue to increase the number of Kaizen events in the quarter. We've nearly doubled them year-to-date compared to 2018. Our restructuring and footprint optimization continues with the ramp up of Tijuana progressing as planned. We are still on track to achieve a 10% reduction in the total number of manufacturing locations by the end of 2019. As Russ has mentioned our full-year 2019 outlook remains consistent with the update provided on our second quarter earnings call. Before we move to Q&A, now that I've crossed the 100-day mark with Masonite, I'd like to provide you with an update on some of my observations here and discuss a number of my first actions as CEO. This team has worked incredibly hard making incremental improvements throughout the business-to-date, and we are on a clear path of continuous improvement. I appreciate these efforts. However, I also acknowledge that it has been a slow and challenging journey, sometimes taking 2 steps forward and one step back. Despite our investments to drive incremental improvements in our efforts over the past several years to obtain a fair value for our products, we are still earning one of the lowest margins and returns on capital among building product companies. I believe we can do better; better for Masonite, better for our channel partners, better for our homeowners, and better for our shareholders. To do this requires a meaningful change in thinking and a transformative approach to what we are doing in the business to drive a step change in performance.

After all, our vision is to be the best provider of building products in the eyes of our customers, employees, shareholders, suppliers, and communities. To achieve this with our customers, we must continue to focus on service and delivery and provide a broad portfolio of innovative products. While I'm pleased with the progress the organization has made to increased new product vitality, I believe we have significantly more runway to improve the mix of our portfolio with new and differentiated products. To do this, we must first understand how consumers use our products and better design our offering to suit those needs. Accordingly, for the past several months, we have been working with an external firm that specializes in voice of the customer research. We have received interim updates from the firm as their work progresses and the learnings gathered today to provide an insightful information on the value ascribed to endure by homeowners. Once completed, the VOC will provide us with an understanding of customers' behavior, how they use the product, their needs, and potential differentiation we can address. Understanding customer needs is crucial, and we must be able to quickly address those needs and execute on new product development. As such, Cory Sorice joined us as Masonite's Chief Innovation Officer in August. Cory has over 25 years of marketing, business development, and general management experience. Most recently, he was Vice President and General Manager emerging business for Chamberlain Group Inc, a world leader in garage gate and commercial door access. Before joining Chamberlain, Cory held leadership roles at Stanley Black & Decker Corporation, Newell Rubbermaid, and the market research firm information resources. He's a named inventor on 10 US patents and has a history of developing new products and systems that add value to customers. I believe that under Cory's leadership, we will drive more innovative new products and continue to differentiate Masonite's offering in our customers' eyes.

Now I'd like to address our recently communicated pricing initiative for the North American business. We typically don't discuss price increases before they become effective, but we expect our recent 2020 customer price communication to generate a number of questions from the investment community, and we feel it better to address it now. Lastly, we communicated price increases to our North American residential customers effective on orders placed beginning February 3, 2020. The price increases are significantly higher than recent years with increases as high as 25% on certain product lines and a total weighted average in the mid-teens. We believe these increases are justified as recent market research indicates that homeowners expect to pay significantly more for interior doors than current pricing levels. Further, this pricing action is necessary for us to make meaningful incremental investments in strategic initiatives with the goal of a long-term sustainable growth. We continue to drive operational improvements and utilize the MVantage operating system to increase efficiencies in our manufacturing and distribution processes wherever possible. To achieve the levels of service and quality our customers expect, we plan to make further investments in plant capabilities, including targeted automation initiatives. This is an asset intensive business, and we need to make adequate investments to ensure we deliver extraordinary service and quality as well as ensuring the safety of our employees. We believe we can create innovative new products that will not only drive incremental sales but improve the mix of higher average unit price products. This is not only beneficial for us but for our customers and homeowners.

Finally, our most recent outside research provides interesting trade and homeowner segmentation. We believe that through targeted end-user marketing, we can continue to change the conversation around doors, improve our brand position, and drive incremental demand which would benefit both us and our customers. To accomplish our goals and improve service and quality, new product innovation and homeowner marketing, we've advised our distributors and retail partners. We intend to invest an incremental $100 million over the next 5 years in these 3 areas. We believe this re-energize focus and investment will not only benefit Masonite in the long term, but our customers and ultimately homeowners.

With that, I'd like to open the call to questions, operator.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Michael Rehaut with JPMorgan.

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Elad Elie Hillman, JP Morgan Chase & Co, Research Division - Analyst [2]

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This is Elad on for Mike. Just wanted to follow up on the hitting than the lower end of your EBITDA guide for the full year. So if I do the math, it implies roughly 150-200 basis points potential step down in margin in 4Q and I appreciate some of the color you gave, but maybe you could help us square how to think about that relative decline by segment and how much of that relates to the higher corporate expense. Thanks.

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [3]

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Yes. Hi, Elad, it's Russ. I'll take a shot at that. I made it a point to frame out some of the aspects of Q4 that would lead to less (inaudible) the margin growth in Q4 than you've seen in the last quarter or two. A lot of it is going to be in corporate expense, the fact that we reduced our incentive compensation accruals last year, whereas we would not expect that to repeat this year that would be an impact to largely corporate expense being higher this year versus last. The other items around, we also noted legal expense also a corporate item, the items around start-up costs would largely impact North American residential business, we're seeing the continued ramp up of our Verdi cut-stock plant, that plant is running very well at this point, but there is still some ramp up in the schedule for that site. The largest portion of it though really comes to the Tier 1 Mexico plant, which as we noted is now ramped up and actually shipped its first product in October, but there's still a fair ramp-up curve ahead of us in Q4 and so start-up costs associated with that would accrue to the North American residential business.

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Elad Elie Hillman, JP Morgan Chase & Co, Research Division - Analyst [4]

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Okay, great. And then can you also talk about some of the monthly trends in the broader wholesale market again on the US you mentioned, it's continuing to be weak or do you haven't seen any of the benefit yet from the positive single family starts in the US and maybe when do you start to expect to see some of that benefit and how should we think about that relative to the offsets in the fewer doors and entry level homes. Thanks.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [5]

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Thanks a lot, this is Howard. I'd say that the demand we've seen has been pretty consistent and continues to be pretty consistent. So we'd call it soft. Certainly, there is a lag between starts and when homes new doors, and we would expect that lag typically 3 to 6 months-ish, but there is headwinds as I mentioned in my script about entry level homes and likely with fewer doors. So the 2 will offset one another to some extent, but so far year-to-date, we've seen pretty consistent trends throughout our markets.

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [6]

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Yes, I going to just add. I'm sorry, it's Russ, I just going to add to that point. When you take a look at the business in wholesale in North America, certainly, a significant part of that slowdown was in the US and Canada, we do attribute that largely to housing. But don't forget, we've also commented on the fact that we also purposely thrift in some of the SKUs that we were offering in Mexico and that did have an impact on AUP as well as base volume, so that was roughly a quarter of the wholesale volume decline that we saw in North American residential.

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Operator [7]

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Our next question comes from Mike Dahl with RBC Capital Markets.

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Michael Glaser Dahl, RBC Capital Markets, Research Division - MD of U.S. Homebuilders & Building Products [8]

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Howard, I wanted to start with some of your closing remarks around some of them, the more transformative initiatives and you laid out some of the things around price then there was also discussion about the SKU rationalization, early in the opening remarks. I just wanted to dig in a little bit more on these. So I guess are these kind of 2 of the biggest what you would call transformative initiatives that you see or what else should we expect and then the part 2 of that question is around the pricing and gross it alluded to there being maybe a little volatility, and I'm wondering if that comment was directly related to these significant price increases and the conversations that you've had early on with your customers, so maybe a little more color on how those conversations have progressed.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [9]

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Sure I'll start Mike and then I'll turn it over to Tony to talk a little bit more specifically about the customer reaction. As first transformative actions, we remain focused on enhancing our brand position in the door category. It's very important, and we want this not only Masonite I'd prefer our channel partners as well. And as such, I believe we need to invest in these key things that I discussed at the end of the call, specifically related to service and quality improvements, new product innovation that we can again address some of the needs and use cases of our consumers with clever new products and then targeted end-user marketing. And I think between those things and really more heavily in service and quality improvements early. Secondarily, new product development and then sort of transitioning to a targeted marketing approach, we think it's can transform the business, not only for Masonite but for our channel partners, as well.

As far as the pricing goes, we've done a significant amount of market research, and we've revealed that there is very minimal price sensitivity amongst consumers. Homeowners generally expect to pay more for their interior doors and many actually described to the fact that the current price ranges are often seen as poor quality, and so we think there is an opportunity there, of course, we intend on making some immediate improvements to the products. And then a longer-term plan for continued improvements, new product development and marketing.

I'll let Tony talk specifically about the reaction from the customers.

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James A. Hair, Masonite International Corporation - President of Global Residential Business [10]

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Yes, Mike. So we rolled our communications last week. And as you would expect there, some surprise at the magnitude of increases on interior doors, although customers were encouraged to learn about the consumer and homeowners expectation to pay more to replace interior doors and most of those customers understand the margin profile of the business and have seen benefits from other building products companies investing in the differentiation to drive demand and in that that 3 pillars that Howard had spoken about, and we believe these strategies will help us drive sustainable growth for the customers as well as ourselves.

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Michael Glaser Dahl, RBC Capital Markets, Research Division - MD of U.S. Homebuilders & Building Products [11]

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Okay, thank you. Just as a follow-up to that, as you know, this is something where years back some of the more step function change in pricing, I think, was driven by some similar work, but I believe was kind of more in partnership with your retail channel partners, and a bit of a kind of process to get the pricing through and you also had some alignment in terms of other manufacturers pursuing similar strategies, so this one seems like it's a little more Masonite being the leader on this, so I'm just curious about are you seeing signs that your competitors are following suit and with these conversations with the retail partners did they start prior to the rollout or was this really a decision to try to lead change and really push your customers to follow?

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [12]

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Dahl, think it's appropriate to comment on what the competitors may or may not do. This is purely a Masonite decision for what we believe we need to do for our business, our customers, our channel partners and our shareholders.

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Operator [13]

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Our next question comes from Michael Wood with Nomura.

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Michael Robert Wood, Nomura Securities Co. Ltd., Research Division - Research Analyst [14]

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I understand the consumer expectation to pay more price for the doors, but we have seen retailers really not want to push price for fear of slowing demand and the impact that might have on traffic. So I'm curious what you're thinking in terms of what could be the volume impact from these price initiatives and both in terms of demand in mix. We have seen both of that in other building product categories that have taken price.

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [15]

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Well, obviously, Mike. Thanks for the question. This wasn't a snap decision that we've done a lot of significant internal review, and we think it's the right move at the right time for us and our customer partners. So we're going to move forward, we've obviously put a lot of thought into this direction. And we've had the complete engagement of not only the leadership team, but the Board of Directors, and we believe it's the right direction for our company going forward.

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Michael Robert Wood, Nomura Securities Co. Ltd., Research Division - Research Analyst [16]

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Okay. And in the quarter just sticking with price, the AUP did decelerate in terms of growth in North America Residential, was this from mix or price weighted more to one or the other, and I guess, can you give us color in terms of how much of that was just simply the lapping prior year increases versus any sequential changes?

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [17]

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Yes, Mike. It's Russ. I'll take that. When it was principally the lapping recall that we took pricing in the wholesale channel in July of last year. And then another increase across all channels and products in December. Most of the step down you see in AUP grow sequentially from Q2 to Q3 was just the fact that we lapped our wholesale price increase in from July of last year. I was also a little bit of a mix headwind there just in that we had relative performance, stronger on the interior side than the entry side, but it was principally the lapping of the July increases.

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Michael Robert Wood, Nomura Securities Co. Ltd., Research Division - Research Analyst [18]

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Okay. Just finally, could you give us the impact that the Canadian Mexican weakness had in third quarter volume in that North American residential business similar or worse than in 2Q impact and what would you expect for that going into fourth quarter.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [19]

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It was not a material impact for the business. If you look at the total -- if you talked about I think you mentioned FX, but I think your question is really around the impact of the SKUs that were rationalized in Mexico, about a quarter of the decline that we saw in base volume in the North American Res business was associated with that thrifting the portfolio. I heard your question correctly.

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Operator [20]

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Our next question comes from Reuben Garner with Seaport Global Securities.

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Reuben Garner, Seaport Global Securities LLC, Research Division - Associate Analyst [21]

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Maybe just following up on that last question, so you're anniversarying, I guess, correct me if I'm wrong, but I think you're going to anniversary some of those calling moves in Mexico as we exit the third quarter one is that correct and 2 with the recent kind of improvement in the start environment and kind of lapping some of those portfolio decisions, do you think you get to the point where volume growth returns as we get into the fourth quarter or is that something that maybe it's more of a 2020 event, obviously depending on how the market reacts to your pricing decisions?

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [22]

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Reuben, it's Russ. Maybe I'll start and then Tony can offer some additional color on what we're seeing market dynamics and demand-wise. Relative to the lapping of this thrifting of the portfolio in Mexico, we will still have some carryover into Q4 as this probably more directly answers the question, Mike asked just before, you will still see carryover in Q4 similar to that you saw in Q3, your relative to the end-market demand, we're certainly hearing very constructive comments from the builders in particular, order flow seems to be improving. We are though seeing this continued evidence of strength at the entry-level of the market. And so if you take a look at activity in the third quarter in particular, we did see housing completions in Q3 up low-single digits, but again with more of an index to the entry level homes, which is [probably] blending the volume of demand we're seeing for interior doors and then Canada also remains weak. If you take a look at the (inaudible) activity in single-family homes in Canada, in the first and second quarter of this year, it was meaningfully down, and so we believe that's reading through into a pretty weak completions environment in that market. Tony anything to add there?

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James A. Hair, Masonite International Corporation - President of Global Residential Business [23]

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I think Reuben, exactly as Russ said, the thing that we're looking at in the US market is this move toward more entry-level and you were into your doors in those homes being built. So we're watching that dynamic to understand what that looks like. We're encouraged by the builder report that they have on new orders and contracts, but we're watching that makes the entry level.

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Reuben Garner, Seaport Global Securities LLC, Research Division - Associate Analyst [24]

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Is there any way to quantify going forward over the next couple of years, what kind of drag that is, I mean if we told you, there was going to be kind of a mid-single-digit starts environment next year and it's going to be driven -- continue to be driven by the entry-level, what kind of volume drag do you think there is on the door industry broadly?

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [25]

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Yes, Reuben its' Russ, I guess I would point you back to some analysis that we presented, I believe it was on the first order (inaudible), where we had run a statistical correlation between size of home and the number of interior doors. And so you do clearly see that is the square footage of a home drops, I believe it was for every 180 square feet of square footage reduction or increase you would see a reduction or increase in the number of interior doors by one, so this is really a function I think where we see the growth going forward. We don't have any specific predictions to offer today as to what entry level percentage is going to be of total starts over the next 12 to 24 months. But based on what we're seeing right now, there's clearly a trend toward growth in the entry level segment that had been frankly under served the last couple of years and that's why we think that we're seeing this natural compression on the volume demand in the new channel, it is a smaller square footage footprint of homes that we're seeing build presently.

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Reuben Garner, Seaport Global Securities LLC, Research Division - Associate Analyst [26]

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Got it. And then last one from me -- sneak one in. So the incremental $100 million of investment over the next 3 years. Can you talk about I guess one, does that change your targeted margin levels at all. And two, I guess what the split is between how much of this is going to be capital investment versus operational and what impact, if any, it has on your cash flow profile? Thank you, guys.

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [27]

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Yes, Reuben. It's Russ. Well, first let me ground us here -- we've consistently invested $70 million to $80 million in CapEx over the last couple of years and that's primarily been associated with operational maintenance and improvement initiatives. And frankly, that's a level of investment that's driven in part by the significant scale of the manufacturing assets that we operate to serve the industry. Now at this point, we would not expect that range of capital spending to materially increase, but we do believe there is an opportunity to invest in some other areas of the business and capabilities and ultimately are designed to benefit our customers. So examples, could include strategic investments in materials to improve product quality or the ease of shipping and handling for our products. It could be inventory management practices that will allow us to be more responsive and shorten our lead times that will benefit our customers. It could be the form of additional engineering resources to allow us to bring better manufacturing processes or new product programs online more quickly. So looked at through that lens, this is not a meaningful change in our capital spending or cash flow profile per se, it's probably more operational expense investments to improve our capabilities in those areas -- on behalf of not only (inaudible), but our customers, and this is an effort that if we want to make sustainable progress in these 3 focus areas; service and quality, product innovation, and marketing that drives down channel demand, it's going to take some commitment over time and that's why we're metering this investment out over a 5-year period. The near-term focus will be more on the service and quality side morphing into more of a focus longer term, on product innovation and marketing.

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Operator [28]

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(Operator Instructions) Our next question comes from John Baugh with Stifel.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [29]

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Quickly in R&R side of the world. Thank you talked about your shipments matching POS more so in Q3 than Q2. Is there any commentary around POS trends in general and how you're seeing the R&R market now and how you see it next year particularly in light of the pricing, it seems like your research (inaudible) don't expect the consumer to react in the retail channel very much [curious] your thoughts there. Thank you.

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James A. Hair, Masonite International Corporation - President of Global Residential Business [30]

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Yes, John, this is Tony. I would say that our POS dynamics were fairly consistent between Q2 and Q3 and orders in Q3 closely follow those POS measures. So we felt good about where we were -- I think the research that we've done more recently to say consumers expect to pay more for replacement here doors is encouraging. And so we believe that the moves we're making in price, while substantially impacted consumer given those expectations and that's part of the confidence we have in part of what we shared with customers and going into this increase.

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John Allen Baugh, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [31]

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Do you expect as a follow-up some kind of spike in orders in front of what was at February 3rd, I think, and where is that sort of in the middle of the quarter, so maybe there is the fall off and we don't need to worry about Q1 impacts overall or any help there.

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [32]

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Yes, John it's Russ. I'll take that. We typically expect some pre-buy activity ahead of announced price increases. Although, historically it's been unusual to see a significant pre-buy volume simply due to the space it's required to store doors in relation to their value. Now frankly it's difficult to predict if the more significant increases that we've just announced for certain product categories are going to influence behavior perhaps differently this round and we've seen recently, and given the effective date of the price increase being February 3rd, hard to predict if we will see any of that yet in the Q4 period or is that's going to be principally a January pre-buy activity. So more to come on that, we're going to wait and see what the customer reaction is and what ultimate demand is. But at the end of the day, that was why I made the comments I did during the scripted portion of the call about potential volatility in demand here coming into the fourth quarter is we need to see what reaction is going to be on a pre-buy basis.

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Operator [33]

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Our next question comes from Kevin Hocevar Northcoast Research.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [34]

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You've mentioned acquired a small door component business in the Czech Republic, so (inaudible) curious what's the strategy in Europe going forward, it seems like the folks had been to grow the UK years ago and divest everything else and here, it looks like you're got something outside of the UK here in the Czech Republic. So curious is that the start of something or is this like you said, it's just a plug [were] fills a hole synergistic and that's that or do you expect to look to grow that Europe business more.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [35]

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Yes, Kevin. Thanks for the question, this is Howard. No, we're not looking specifically to expand really and either -- rationale this recent acquisition was that we didn't have a fully integrated frame production in that market unlike most all of our competitors. So this was really an opportunity to acquire a very synergistic business at a very minimal investment.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [36]

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Got you. Okay. And then the corporate expense had been running, has been running about $10 million per quarter here, the last 2 quarters it looks like this year is on pace for much higher than usual corporate expense. So how should we think about that going forward, is this an elevated year and it should come down next year or -- and Russ you mentioned the 3 cost, a couple of cost, I guess the ramp up in the facilities and incentive comp and higher legal costs impact in the fourth quarter anyway you could quantify how much all that is going to be a headwind in the fourth quarter?

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [37]

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Yes, I can give you some general ranges around it. First of all, the start-up costs, which again would not fall a corporate they would lie in the North American residential segment, we would anticipate that could be on the order of about a $1 billion headwinds in the fourth quarter. The items that are going to be impacting the corporate sector from the legal cost perspective, we think that could be in the range of a $2 million headwind year-on-year in the fourth quarter and then from an incentive comp perspective, in the prior year period Q4 '18, we actually pulled our incentive comp accruals down circa $4 million, and we would not expect that would repeat this year. So that's really the rough values we would put around the 3 items that I called out specifically.

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Kevin William Hocevar, Northcoast Research Partners, LLC - VP & Equity Research Analyst [38]

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Got you. Okay. And then in terms of, it seems like it's an elevated number this year, would you expect a similar corporate expense next year or would you expect that to come down.

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [39]

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I think that it may come down slightly, but we're still modeling out what the impact is going to be on various corporate expenses, not here to break any news on what the 2020 outlook is at this point. We do have a probably the largest single dynamic and volatility for corporate expense this year versus last is incentive compensation because based on the performance that we saw in 2018, we saw a pretty meaningful step down to the accruals we took not only in the short-term incentive programs, but also our LTIP programs. And we would hope that -- wouldn't see that on an ongoing basis, you're seeing a swing back in 2019 as we normalize those accruals more in line with targeted levels. And that would be more representative of what you should see going forward.

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Operator [40]

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(Operator Instructions) Our next question comes from Trey Grooms with Stephens.

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Noah Christopher Merkousko, Stephens Inc., Research Division - Research Associate [41]

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This is actually Noah on for Trey Grooms. My first question is, it looks like architectural volumes were down slightly. Are you guys seeing any deceleration there and is that primarily related to the commercial end market?

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [42]

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No, I think it's just, -- it was down like less than 1%, and I think it's just quarter-to-quarter fluctuations actually, I don't think that's probably market related.

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Noah Christopher Merkousko, Stephens Inc., Research Division - Research Associate [43]

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Sorry, go ahead.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [44]

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No, no, I was just confirming that is generally the trend that we're seeing in the market, there is nothing specific that we're seeing in that business. Actually as we pointed out in the call, I would actually note that again. We're real happy with certain parts of that business. The quick-ship part of the business in particular is showing continued strong growth. So that aspect of it we like a lot.

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Noah Christopher Merkousko, Stephens Inc., Research Division - Research Associate [45]

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Got you. And then just a quick follow-up, the Canadian resi market has been weak for some time now, it looks like at least in the US that might be the turning around. So if you're seeing any light at the end of the tunnel for the Canadian market or so what's your outlook there.

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James A. Hair, Masonite International Corporation - President of Global Residential Business [46]

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Yes, I think -- I mean is this is Tony. We continue to monitor what's going on in Canada, and we see a lot of fluctuation in multifamily, as we've seen consistent downtrend in single-family. So I don't really have a good crystal ball on what's going to happen in that marketplace. We feel comfortable with customer partners we have and the penetration we have, and we'll just have to wait and see what that's going to do.

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Operator [47]

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Our next question comes from Jay McCanless with Wedbush.

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Jay McCanless, Wedbush Securities Inc., Research Division - SVP of Equity Research [48]

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Hi, my questions have been answered. Thank you.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [49]

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All right, thank you, James.

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Operator [50]

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Our next question comes from Steven Ramsey with Thompson Research Group.

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Steven Ramsey, Thompson Research Group, LLC - Senior Equity Research Analyst [51]

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I guess to start on pricing, you had mentioned that -- this is kind of the right time to do it and you have long talked about the gap of door pricing compared to other residential products, but why is now the right time versus 2 years ago maybe when in-markets were stronger?

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [52]

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It's good question, Steven. I think that we've long recognized that the value that both us and our customer partners receive for our products and services is below expectations and for some time, we've attempted to address this through pricing and productivity, new product mix, et cetera, and despite this, we continue to earn, one of the lowest margins and returns on capital amongst our peer group, and so while we've made progress, it's always sort of been partially, at least partially consumed by commodity inflation and labor inflation and distribution costs, et cetera. So, I think today with our operations and footprint and service continuing to improve, we're taking measures to support this significant incremental investment we talked about, to earn a fair return on the assets we have invested to produce and deliver our products.

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Steven Ramsey, Thompson Research Group, LLC - Senior Equity Research Analyst [53]

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Great. And then on the $100 million investment observed I missed this, how does that get phased in. And then I guess with the transparency on the pricing in that you've given to us and customers especially, does that mean you won't be, or shouldn't be doing as much share repurchases. Just from a PR perspective?

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Russell T. Tiejema, Masonite International Corporation - Executive VP & CFO [54]

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Yes, Steven. It's Russ. First of all, I mean I could comment in any way and what our forward repurchase strategy would be, I would however point you back to the comments that I made a moment ago about the fact that we're not expecting any kind of meaningful change in our capital expenditure spending levels or cash flow necessarily related to that. So this is just a matter of where we invest in additional operational capabilities, whether that is in our engineering resources, our product development resources, distribution and logistics practices, and things like inventory management and material within our products to improve their quality and performance on behalf of both our customers, our channel partners, that is end-homeowners that ultimately use the product. So as I mentioned, also earlier, the focus in the near term is going to be on service and quality. The things that are really most impactful for our customers and will generate the greatest value for them in the near term, and then we'll shift more of that spending footprint over time toward product innovation and marketing efforts to continue driving additional down-channel demand on the back of even higher levels of service and quality that we're able to provide today.

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Operator [55]

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There are no further questions at this time, I'd like to turn the call back to Mr. Howard Heckes for closing comments.

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Howard Carl Heckes, Masonite International Corporation - President, CEO & Director [56]

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Thank you, Rob, and thank you for joining us today. We appreciate your interest and your continued support this concludes our call. Operator, please provide replay instructions.

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Operator [57]

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Thank you for joining Masonite's third quarter 2019 earnings conference call. This conference call is being recorded. The replay may be accessed until November 19. To access the replay, please dial (877) 660-6853 and that is within the United States or (201) 612-7415 which is outside of the United States, and please enter conference ID 13695345. This concludes today's conference. You may disconnect your lines at this time, and we thank you for your participation.