Aug 2, 2012
Operator
Good day, ladies and gentlemen, and welcome to the Gibraltar Industries Second Quarter 2012 Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to your host for today, Mr.
David Calusdian, from the Investor Relations firm Sharon Merrill. Please proceed, sir.
David Calusdian
Good morning, everyone, and thank you for joining us. If you have not received a copy of the earnings press release that was issued this morning, you can find it in the Investor Info section of the Gibraltar website, gibraltar1.com.
During the prepared remarks today, management will be referring to presentation slides that summarize the company's performance. These slides are also posted on the website.
David Calusdian
Please turn to Slide #2 in the presentation. Gibraltar's earnings release and this morning's slide presentation both contain adjusted non-GAAP financial measures.
Reconciliations of GAAP to adjusted measures have been appended to the earnings release. Additionally, the company's remarks contain forward-looking statements about future financial results.
The company's actual results may differ materially from the anticipated events, performance or results expressed or implied by these forward-looking statements. Gibraltar advises you to read the risk factors detailed in its SEC filings, which can also be accessed through the company's website.
David Calusdian
On our call this morning are Gibraltar's Chairman and CEO, Brian Lipke; Henning Kornbrekke, President and Chief Operating Officer; and its CFO, Ken Smith.
David Calusdian
At this point, I will turn the call over to Brian.
Brian Lipke
Thank you, David. Good morning, everyone, and thanks for joining us on our call today.
I'll begin as usual with some brief comments and then turn the call over to Henning and Ken for a more detailed review of our results. And then I'll close our prepared remarks with observations about our business outlook.
And then following that, we'll open the call to any questions that any of you may have.
Brian Lipke
I'll begin my remarks by referring to Slide #3 in our presentation. Entering this year and through the first quarter, we felt optimistic that improving end market conditions and stronger GDP would drive greater organic revenue growth in our business.
However, recent economic data on the second quarter reflected slower demand than we and many industry observers had anticipated. Nonetheless, our revenues grew 5% this quarter, with contributions from organic growth, as well as acquisitions.
Additionally, this was a challenging quarter on the bottom line, as we faced more competition in key markets as we worked our way through an expanded reorganization of our West Coast residential operations.
Brian Lipke
Nonetheless, as Henning and Ken will discuss, we strengthened Gibraltar's presence in product categories and in end markets that we expect will yield improved performance results as our markets recover more meaningfully. We're also focused on improving our underlying operations, tightly controlling costs and increasing the margin leverage in our business.
In addition, with our strong balance sheet and increased liquidity, we're in an excellent position to acquire product lines that complement our organic growth and expand our range of products. As a result, we still expect to deliver stronger financial results in 2012 than we did in 2011 in spite of continuing historic low levels of end market activity.
Brian Lipke
I'll refer to Slide 4 now, which focuses on the positioning and new product categories and end markets that I just mentioned. During the past 3 years through organic growth, acquisitions and divestitures, we have expanded our presence in the nonresidential, industrial and infrastructure end markets to approximately 50% of our current total sales from 30% in 2008.
Our sales on these markets are about evenly split between the building construction, infrastructure and industrial sectors, with 55% of that being driven by repair, remodeling and replacement applications. This diversification has enabled us to offset weak demand in housing and drive growth and profitability in the business as demonstrated by the contribution made by D.S.
Brown in the second quarter. So in short, we're making progress in strengthening our business and improving our performance, in spite of weak end market conditions.
All of this progress will be leveraged to greater bottom line growth as our end markets improve.
Brian Lipke
Henning and Ken will review our second quarter results in greater detail, and then I'll conclude our prepared remarks with some additional comments on the outlook. Henning?
Henning Kornbrekke
Thanks, Brian. Turning now to Slide #5, I'll begin with a closer look at our top line for the quarter.
Our 5% revenue increase in Q2 was fueled by increases to infrastructure and industrial end markets, principally, higher volume for grating, perforated and expanded metal products and industrial applications such as filtration and energy production platforms and new applications such as architectural exterior facades. Looking forward, we continue to see excellent potential for exposure to all such markets that we serve worldwide.
And it was another solid quarter for our infrastructure business as shipments from its backlog helped us reach record quarterly sales.
Henning Kornbrekke
Looking specifically at the infrastructure business, we continue to exceed our initial expectations. We're continuing to see solid growth in our backlog, which remains near record levels at the end of June.
As in the first quarter, sales and backlog growth were driven by a good mix of bridge and highway-related opportunities.
Henning Kornbrekke
We are continuing to penetrate additional markets. For example, by supplying product to offshore oil production platforms and further expanding its presence in Europe.
In addition, the recent passage of a new 2-year transportation bill should help provide additional demand with funding certainty for the next 2 years. Additionally, our metal grating business in Canada that we acquired in the first quarter of 2012 also is performing well, serving the oil and gas sector in Western Canada.
Henning Kornbrekke
Regarding residential markets, housing starts, residential and nonresidential building and residential repair and remodeling activity were all slower than we had anticipated going into the year. The work we've done to position Gibraltar as the leader in the majority of our product categories enabled us to continue delivering good [ph] sales growth despite these challenges.
We've launched new products and improved our penetration of existing nationwide customer accounts. At the same time, we've dramatically strengthened our customer service orientation, and we're continuing to increase our overall market share as a result.
Henning Kornbrekke
Residential and nonresidential new building activity has increased modestly for the nation as a whole but some parts of the country are still lagging, and the growth, overall, remains persistently weak. As a result, our retail and wholesale customers have not increased inventories to any meaningful extent.
Our residential repair and remodeling activity has remained somewhat resilient because of our tie in to smaller projects and necessary repairs like reroofing, while consumers are still very cautious and postponing larger home improvement projects where they can. Our quarter 2 sales into the home center channel were favorable to Q2 a year ago.
Henning Kornbrekke
Looking at the retail channel specifically, we're offering targeted programs to our home center customers on a region-by-region basis. Along with special programs, we're focusing on providing quality products on a competitive basis, while also expanding our offerings with product and market innovations regionally and nationally.
These initiatives are continuing to strengthen our presence in the home center channel. We're making comparable progress penetrating the wholesale channel as well, fueled by our extensive geographic coverage, broad line of products, compelling marketing and merchandising programs and proving manufacturing capacity.
We delivered revenue growth and higher unit volume in spite of competitive market conditions. We've made strategic decisions on pricing with our customers to maintain, and in some cases, gain market share from our competitors.
Henning Kornbrekke
Please turn to Slide #6. Our strategy remains positioning the business, so that we can be efficient and profitable even at low demand levels in our major end markets.
Our restructuring has been completed with the exception of the West Coast operations, which is planned to be completed early in 2013. This leaves the company poised for profitable growth at an accelerated pace as our end markets recover.
We strive for continuous improvement in the businesses, as was the case of the second quarter, focusing primarily on completing the integration, consolidation of manufacturing and distribution facilities and business restructuring in the West Coast region, following last year's acquisition of Pacific Award Metals. We completed the process of closing facilities in Kansas City and Denver in Q2, and our plans to close a second West Coast facility during the second half of 2012 remain on track.
Henning Kornbrekke
As I said last quarter, we considered consolidating more small facilities, in connection with the West Coast consolidation, but have decided on closing a single very large facility later this year, which is the reason why the process is taking longer than we expected. We are combining 4 separate West Coast businesses with similar products and market characteristics into a single entity with market differentiators that provide benefits to our customers.
The cost of our ongoing integration of the Award Metals acquisition with our West Coast residential businesses, including a significant inventory write-down related to this initiative negatively affected the margins this quarter. We expect this project to gradually contribute to Gibraltar's earnings during the next 2 quarters.
We expect to accomplish our gross margin objectives for these West Coast initiatives by year-end, while also building a retail and wholesale delivery platform capable of supporting significant growth and sales.
Henning Kornbrekke
The intensified competitiveness in some of our end markets dampened our margins in the second quarter. Much of this was driven by continued low demand levels, which should diminish as market conditions improve.
We are committed to improving our profitability by managing the cost side of the business, including the material's pricing equation and purchase price variance. We're making good progress with asset management at targeted levels of excellence.
The systems investments we've made in recent years are aiding our asset management in all of our business units.
Henning Kornbrekke
We previously stated that we expect commodity costs to have less impact on our margins in 2012 than they did in 2011. Based on our experience, during the first and second quarters, this remains our expectation.
Overall, we're looking forward to accelerating our sales growth and further improving our financial performance in the remainder of 2012.
Henning Kornbrekke
With that, I'll turn the call over to Ken Smith.
Kenneth Smith
Thanks, Henning, and good morning. I'll start by discussing Gibraltar's P&L results, and the P&L information in this presentation represents adjusted measures for continuing operations and our reconciled supplemental schedule's in the earnings press release.
Kenneth Smith
So let's turn to Slide #7 in the presentation and sequential performance. Revenues were up 14% from the first quarter.
This growth was predominately organic and driven by seasonal volume increases in every market we serve, with the only exception being Europe, where we derived approximately 6% of our consolidated revenues. And each of our major residential product categories had double-digit increases compared to Q1.
Kenneth Smith
Adjusted operating income nearly doubled sequentially, driven by the leverage on the higher organic volume, and this improvement included our acquisition of the D.S. Brown Company, which turned in a record quarter for revenue and profitability, as Henning noted.
And regarding adjusted EPS, the sequential increase of $0.19 per diluted share was driven by operating income growth, as well as a small benefit from a discrete income tax item.
Kenneth Smith
Now let's turn to Slide #8 entitled Year-Over-Year Performance. This slide includes year-over-year comparisons for the second quarter, and as well, the first 6 months of 2012.
I'll begin by going down the 3-month columns. Revenue grew 5% for the quarter, largely driven by 3% higher organic sales volume, primarily in the nonresidential and industrial end markets, and 2% of the growth came from acquisitions of Award Metals and Edvan.
Kenneth Smith
Adjusted operating income was down 16% for the 3-month period, and operating margin was down 200 basis points. The net effect of gross margin squeezed [ph] 360 basis points, while SG&A expense as a percent of revenue was lower by 160 basis points.
Approximately half the gross margin decline was driven by competitive end market conditions and less favorable material margin; and the other half from West Coast integration efforts, including a related inventory charge of $2.2 million.
The improved SG&A expense as a percent of revenue came from lower compensation expenses, including lower equity comp. Translating these factors into their effect on adjusted EPS, the bridge from last year's Q2 adjusted EPS of $0.30 to this year's second quarter EPS is summarized as follows
a $0.04 per share increase from leveraging the higher organic growth, driven mainly by sales of infrastructure products and grating and expanded metals product in the nonresidential industrial markets; a $0.03 per share increase from the lower SG&A expenses; and a $0.03 improvement came from a lower effective income tax rate. These increases were offset by a $0.06 per share decrease related to the cost of integrating the West Coast operations, and $0.04 of the $0.06 was the inventory write-down and a combined $0.06 per share decrease related to the narrowed spread between raw material costs and pricing.
The improved SG&A expense as a percent of revenue came from lower compensation expenses, including lower equity comp. Translating these factors into their effect on adjusted EPS, the bridge from last year's Q2 adjusted EPS of $0.30 to this year's second quarter EPS is summarized as follows
Now going down the 6-month columns. Revenue grew 11% for the half, half year.
This growth was largely driven by the 3 acquisitions, the first of which came in early April 2011. The 3 acquired businesses added $26 billion or 7% to revenue for the first half this year.
The organic increase amounted to a 4% increase and came equally from residential and nonresidential markets, and largely, volume growth.
The improved SG&A expense as a percent of revenue came from lower compensation expenses, including lower equity comp. Translating these factors into their effect on adjusted EPS, the bridge from last year's Q2 adjusted EPS of $0.30 to this year's second quarter EPS is summarized as follows
Adjusted operating income was down 12% for the 6-month period, and the operating margin was down 170 basis points, matching the gross margin decrease of 170 basis points, while SG&A expense as a percent of revenue remained unchanged. A large majority of the gross margin decline resulted from the cost of the West Coast integration effort, including the inventory charge of $2.2 million, and we expect the largest portions of the integration costs have been incurred.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
a 9% -- or I'm sorry, a $0.09 per share increase from the combined contribution of organic growth and incremental effect of the acquisitions led by D.S. Brown; a $0.03 improvement came from the lower income tax rate; and these positives were offset by an $0.11 share -- per share decrease related to the cost of integrating our West Coast operations; and a combined $0.05 per share decrease predominately related to the narrowed spread on material costs and customer pricing.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
And regarding free cash flow, the amounts shown on Slide 8 reflect our historical pattern of a seasonal investment and working capital in the first quarters followed in the second quarter's with converting a portion of that back into cash.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
Turning to Slide #9, titled Net Income and EPS. I've already described the changes in operating income, so my remarks on this page and this slide regard interest expense and income taxes.
Interest expense was higher in the Q2 of 2011 due to funds borrowed under our revolving credit facility to help finance the acquisitions of D.S. Brown and Award Metals last year compared to no amounts outstanding on our revolver during the second quarter of 2012.
Interest expense for the half year decreased, a net result of higher borrowings on the revolver last year, as well as interest income earned last year on a note receivable from a 2008 divestiture.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
Regarding income taxes, we recognized a much lower effective tax rate for both the quarter and half year of 2012. The 34% rate for Q2 2012 compares favorably to the 42% rate in Q2 last year due to a 5 percentage point reduction on the reversal of an uncertain tax position after the recent completion of a tax audit, plus lower nondeductible expenses this quarter.
The 6-month 2012 rate of 35% was lower than the 43% a year ago for the same reasons.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
Now turning to Slide #9, titled Continued Low Net Debt. We ended the second quarter with an increase in cash compared to March end, having converted some of our seasonal investment and working capital.
We also continued to have positions of loan debt to capitalization and net debt to net capitalization. We've not had borrowings against our revolver since mid-September 2011.
We continue to have a conservative debt level and no near-term debt maturities. Our leverage ratio at the end of June was 3.1x and our liquidity increased again to $194 million at the end of June.
With a strong balance sheet, lower leverage and ample liquidity, we're strongly positioned to finance organic and acquisition-driven growth opportunities going forward.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
I'll conclude with comments on our updated P&L expectations for 2012. As both Brian and Henning stated earlier, the growth we've seen in our end markets is somewhat slower than we anticipated going into the year.
The market indices and published reports of various industry observers underscore a mixed outlook. For example, the National Association of Homebuilders report, in their housing market index for July stated that while builder confidence is improving, housing is still in a fragile state of recovery.
In the American Institute of Architects' Architecture Billings Index dropped for the third consecutive month to 45 in May and essentially at that same level for June, foreshadowing softer demand in the multifamily institutional markets and flat design in construction activity in the commercial and industrial markets. And as you know, the recent report on second quarter GDP growth in the U.S.
fell to 1.5%. These and other published reports plus our own order rates thus far in Q3 suggest that our organic growth for the second half may slow a bit and yield an approximate 2% organic growth rate for the full year 2012.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
Our expectation for the third quarter of 2012 compared to Q3 2011 is for comparable adjusted earnings per share on modestly lower revenue, with an improved operating margin led by lower West Coast restructuring cost. And for the fourth quarter of 2012, which is a seasonally low quarter for revenue, earnings showed improved compared to Q4 2011 based on improved efficiency in our West Coast operations plus much lower SG&A expense.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
For the full year 2012 P&L, we now expect organic revenue growth approximating 2% for our core businesses plus additional revenue from the acquisitions, which could be an incremental $30 million. We expect our gross margin for the full year 2012 to approximate 20% based on our current assumption of slower volume growth in the second half and lower volatility and raw material costs.
It also includes shrinking cost for the completion of our West Coast region reorganization.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
Regarding our SG&A expense for the full year 2012, we expect it to approximate $27 million per quarter and represent about 13% of our full year revenues. Our other expectations for financial measures for continuing operations on an adjusted basis for the full year 2012 include net interest expense at a current run rate of $4.7 million to $4.8 million per quarter, an effective tax rate of 37%, CapEx spending of approximately $15 million to $16 million and free cash flow to approximate 4% of full year revenues.
Translating these factors into the effect on adjusted EPS, the bridge from last year's $0.41 for the first half to this year's first half is summarized as follows
In summary, despite second half economic conditions that appear to be softening in key end markets, we expect full year EPS improvement over 2011. And now Brian has concluding remarks.
Brian Lipke
Thanks, Ken. We have made significant progress in the last few years, leveraging improved profitability from Gibraltar's businesses without the benefits of significant recovery in our end markets.
The drivers of this are summarized on Slide #11.
Brian Lipke
Since late 2007, we've essentially reconfigured the business, reducing our annual operating expenses, managing commodity costs more efficiently and reducing our working capital by nearly half. We've also rationalized and refocused our business portfolio and our product lines through strategic divestitures and acquisitions.
As a result, we've taken share from our competitors in our traditional residential markets, focusing on home repair and remodeling and reducing our sales related to housing starts to approximately 12.5% of our total sales. At the same time, we've grown our presence in the nonresidential, industrial and infrastructure markets from 30% to 50% of our total sales.
Brian Lipke
With organic- and acquisition-driven volume growth and better margins, we've increased our earnings from continuing operations in an environment that overall has been stubbornly resistant to sustained improvement. At the same time, we've maintained significant available capacity to support future growth, generated positive cash flow and strengthened our balance sheet, including reducing our borrowings by nearly half.
Brian Lipke
Looking to drive sales organically, we've developed a product portfolio that addresses diverse and attractive markets, as well as innovative marketing programs and a strong customer service orientation. When we do see meaningful improvement in our end markets, our streamlined cost structure and richer product mix position us for improved profitability as construction activity rebounds.
Brian Lipke
In terms of acquisition-driven growth, our stronger liquidity and positive free cash flow position us to fund strategic additions to our business. We remain actively involved in discussions with a number of small and midsized companies.
These are companies we know as competitors or as suppliers of products that could broaden our portfolio and who's market position and business performance could be enhanced through integration with Gibraltar.
Brian Lipke
As always, we're continuing to be thoughtful and systematic in our approach. Overall, we're optimistic about Gibraltar's prospects.
Given the sales growth we've delivered in the first half of the year, we look forward to regaining our earnings momentum and reporting full year improvement in our financial results for 2012 and into 2013.
Brian Lipke
That concludes our prepared remarks. And at this point, we'll open the call for your questions.
Operator, you can open the call.
Operator
[Operator Instructions] Our first question comes from the line of the Peter Lisnic with Robert W. Baird.
Peter Lisnic
I guess, first question, Ken, if you could, the $0.06, I think it was of West Coast charges in the second quarter, how does that kind of roll forward into the second half of the year?
Kenneth Smith
We expect that we're-- our second half, we'll probably have, I'd say, no more than $1 million of costs related to them.
Peter Lisnic
Okay. perfect.
And then if I look at the price cost equation, I guess, I'm a bit confused with commodities rolling over a bit. It would suggest that you're seeing some price measure in markets, and I think you alluded to that in the comments or press release.
Can you give us a feel for where that price pressure exactly is, how significant it is? And then, does it alleviate at all here in the back half of the year?
Henning Kornbrekke
I think we see the price pressure in all the markets that we serve, both residential, industrial, commercial. There's less business out there, and the folks that are out there vying for the business is -- they're just learning how to be more competitive, and that's forced us to remain far more competitive on pricing as well.
Peter Lisnic
And is there -- is there some point where -- or have you walked away from business, thinking that maybe the returns are just not optimal?
Henning Kornbrekke
Yes, we're very careful. I mean, we are committed to supporting our customers, and therefore we work closely with our customers, providing the right pricing.
And there are some instances where we have walked away from some business. Again, we tend to be very careful how we do that, because we do value the relationships with our customers.
So it's a very touchy issue.
Peter Lisnic
All right. And then should we expect...
Brian Lipke
Pete, let me just add one other thing. We believe that a lot of this is driven by the continued, or even somewhat worsened end market demand levels.
And competitors are everybody -- anybody who has business has become a target, and we're battling back against that. I am confident that as end market conditions improve and demand levels pick up that a lot of that will dissipate and end rather quickly.
Peter Lisnic
So with the back half of the year, I would expect, given the macro uncertainty out there that maybe this continues to be an issue for, at least, the remainder of the year? Is that the right way to think about it?
Brian Lipke
I would say, yes.
Henning Kornbrekke
I think at this point, we are being very conservative in our look, and I think, what we've projected to you all is a very conservative look on the rest of the year. We still believe that there is a pick up coming, and we're all just waiting for when that will start to happen.
Peter Lisnic
Okay. And then last question, if I could, just on the -- Henning, you talked about these targeted programs you have at retail.
Are there any load-in costs that you're incurring there? And then maybe can you give us a feel for what that has been doing to gross margin mix, as those programs kind of kick off?
Henning Kornbrekke
Yes. We've continually provided new products and that's all built into our budgets, so there's no additional load-in costs with any of our programs that we're putting in.
And your second question was?
Peter Lisnic
What sort of impact it's had on mix, if any, in the gross margin line.
Henning Kornbrekke
I think we've seen mix changes in some of our businesses, and that has had negative impact in the second quarter. Some of the products which tend to be more profitable weren't as strong.
We see that starting to change as we go through the rest of the year, fortunately. We noticed that even coming out of the end of July.
So we think the mix will return to a more favorable mix going forward.
Brian Lipke
From a broader perspective, Pete -- this is Brian. Strategically, as we've divested businesses and added new ones, our focus is to position the company for higher overall margin generating capability.
The business we divested last year had become a lower margin generating business, and we replaced it with a significantly higher margin generating business. So overall, we're shifting the business in the right direction.
During any given period of time, there may be a little ups and downs in that. But as an overall statement, our focus and the actions that we've taken has positioned the business for higher overall margin-generating capability.
Operator
Our next question comes from the line of Tim Hayes with Davenport & Company.
Timothy Hayes
A couple questions. On -- just I want to check if I heard the gross margin correct, you're expecting 20% in the second half of the year?
Brian Lipke
That was 20% for the full year.
Henning Kornbrekke
Full year.
Timothy Hayes
Full year. And that's on an adjusted basis?
Yes?
Brian Lipke
Yes?
Timothy Hayes
Okay. Was the first half running just a little under that?
Brian Lipke
Yes.
Timothy Hayes
The comments you made on oil and gas remaining strong, was your sales in Q2 on par with Q1 or up or down versus Q1 and for that end market?
Henning Kornbrekke
I think that end market in total, it was about on target and in line with last year.
Timothy Hayes
And how about -- how did that compare to, say, Q1?
Henning Kornbrekke
I don't know if we've done that comparison.
Timothy Hayes
Okay. Yes, we've just heard some mixed reports on the oil and gas.
Some say its remaining strong, some seeing some weakness. I was wondering, did you get any sense of any sales that were hurt by the switch from gas to oil?
Henning Kornbrekke
No, we have not.
Brian Lipke
Fortunately for us, we're serving both centers of that industry.
Timothy Hayes
Sure, sure. And that's mainly to the metal grating product, or is there any other products that you...
Henning Kornbrekke
Metal grating, with some infrastructure products that we provide as well.
Brian Lipke
D.S. Brown is moving into areas like that.
Operator
[Operator Instructions] Our next question comes from line of Ken Zener with KeyBanc Capital Markets.
Kenneth Zener
I just was reviewing your comments last quarter for growth, it was 4% to 5%, and now we're at 2% -- for organic, and we're now at 2% for 2012, which given roughly a 4% rate in the first half, it assumes nearly standstill growth on the volume side, maybe almost 1%. That's what you're saying, correct, in terms of the shift quarter-to-quarter for the back half?
Brian Lipke
Yes.
Kenneth Zener
Was it so pronounced -- you mentioned inventory oil, gas, you just kind of went through that. How come -- I guess, what do you -- and that's been causing the competitive landscape, but it's -- is it just really -- if you look at the residential side, the volume's down, and the competition is heating up a little bit, is that just -- what is that in your view?
Is that consumer sentiment? I mean, I know you referenced the home builder index, but you cited only 12% of your sales to new sales.
Could you kind of just comment on that perhaps a little bit why it just...
Henning Kornbrekke
Yes. I think the general -- and Brian has some views as well.
But I think the general consensus is that the overall market in the U.S. is down.
It's moving sideways, everyone is very uncertain. And I think it's moving into the markets that we serve.
We see it residential, we see it at wholesale, we see a little bit even on the industrial piece of it. There is a lot of pent-up demand.
We know that in some segments that the building market has started to pick up. We see signs in specific areas where the building -- new building is up 20%.
I think, eventually, that's going to translate through and translate to our business. Again, remember, this is also a phasing.
We tend to participate later, so as building picks up, we eventually will start to see our business pick up as well.
Kenneth Zener
Do you think -- I guess the first half versus the second half, do you -- would you say that the tempering of demand might also be considered somewhat of a pull forward given weather, warmer -- whether it was a milder winter, warmer spring, drier?
Henning Kornbrekke
Everyone talked about the weather conditions. January and February were stronger than usual, and then the months after that were weaker than usual.
And now we're hearing a lot of comments about the unusually hot dry weather through most of the country, which has pushed back demand, particularly on certain roofing projects and other types of expansion projects. And I think that's real.
What that suggests is some pent up demand, which will eventually be released. Will it be released in the fourth quarter, the first quarter?
We don't know yet.
Kenneth Zener
Yes. If you don't mind just expanding on that roofing concept a little bit, because milder winter, less ice, less snow, less damage, less rain in the spring, dry, so you don't know your roof has a hole in it.
But it sounded like you said heat was actually a deterrent there, is that what...
Henning Kornbrekke
Heat does destroy your roofs quite faster than ice and cold weather. The outgassing of the materials is accelerated and shingle roofs need to be replaced at a much faster pace.
And the roofing industry is exhibiting the same sentiments. I mean, and we listen to their reports as well.
Brian Lipke
Ken, a little different perspective on it -- or coming at it from a little different perspective. If you -- you noted accurately that only 12.5% of our sales now go to the new housing market, which means that there's a very big piece that goes to the repair and remodeling market, and a lot of that is simply driven by consumer confidence.
And right now, with 24/7 of badgering, I guess, of the consumer with any kind of -- any broad range of different problems that -- the nuclear situation in Iran, the troubled financial situation throughout all of Europe, what's going to happen with the tax cliff here in the U.S. even though I don't think many of us understand it.
It's still a troubling issue out there. All of the bantering about the presidential election coming up.
I think consumers are just getting more and more conservative about things, and unless they absolutely have to do a repair or remodeling project, I think a lot of them are just holding back. And I think there've been a number of reports that have cited that consumer confidence is down.
And that's, we think, having a significant impact during this period of time. Once some of those things sort themselves out, once the election's done, as Henning pointed out, this is pent-up demand that's building and will be released to the market.
But I think consumer confidence is a big -- or lack thereof is a major factor in this.
Kenneth Zener
Okay. I do appreciate that.
Focusing on the West Coast, $2.2 million charge. I take it that was in gross margin?
Brian Lipke
Yes.
Kenneth Zener
That was not the $0.02 that is a difference between the $0.26 and the $0.28, is that correct?
Kenneth Smith
$0.26 to $0.28.
Kenneth Zener
You had the $0.02 cited, okay, so it's in the $0.28 kind of normalized EPS that you -- as you presented, correct?
Kenneth Smith
Correct, that's included as a charge.
Kenneth Zener
And if I were to add that back to gross margin, just -- since that's a charge, that would have brought your gross margin to a 20.5% rate, which was better than, obviously, 19.5%. But can you just -- we have another $1 million coming over the 3Q and 4Q.
Can you walk us through -- I realize this might take a little longer, but what happened here to the extent you're having charges? Were they anticipated?
What was the catalyst when you got on the ground given kind of recent acquisitions? And what do you think that says about your insight into assessing business dynamics as you're looking at an M&A deal?
Henning Kornbrekke
I think that we're encouraged with what we're doing in the West Coast. I think in the middle of everything that we're doing, the market dropped significantly, and that really changed the tenure of everything we were doing on the West Coast.
But I think we're generally excited. We have an opportunity to put together a platform that no one else in the country has for our customers on the West Coast.
And that's why we decided to invest more heavily in doing it right. And it is taking more time, it has been more expensive, but it is the right thing to do.
And as we finish the project, I think it will be apparent, certainly to our customers and to our P&L that we've moved it in the right direction.
Kenneth Zener
Okay. If I could just get one more question.
Ken, you had a lot of numbers there on the bridge. And I'm waiting for the transcript to come out so I can piece it together.
But it sounded as though the bridge from gross margin, I believe you were doing, was that from year-over-year gross margin change?
Kenneth Smith
I did a bridge on EPS for both -- separately for the quarter and the half year.
Kenneth Zener
Okay. It did sound as though -- so the pricing was roughly half of the shifting -- could you just review that again to clarify the pricing that you've faced as opposed to the steel, because steel fell -- my -- our view, about 8% sequentially looking at the HRC.
It's kind of set to fall that amount again 3Q sequentially from 2Q, yet you're kind of highlighting stable to modestly up gross margin. Could you give us a better feel for how that works, given a flatter sales environment, please?
Kenneth Smith
I talked about a $0.06 decreasing effect on the EPS compared to Q2 a year ago, which was a combined effect of raw material costs and their relationship to average pricing. I did not split it out.
Brian Lipke
Yes, I think when we look at -- just from an operations point of view, the margins were most impacted in the second quarter by mixed material cost and restructuring on the West Coast. If you look at our full year material margins, they're flat with the prior year.
And we expect when we finish this year, full year, we think the material margin will be relatively flat to the prior year. We think the mix will start to change.
Right now the mix is unfavorable, and I'm talking mix, I'm talking 2 mix changes. One is business mix.
We've had more businesses -- more volume on the West Coast, which had lower margins than our other businesses, and we think that's going to change. We also had some product mix issues inside of some of the businesses.
And we see that starting to reverse as well. So on a full year basis, mix should be more in line with what we typically do.
And as Kenneth said, the restructuring in the West Coast will be largely behind us, as we move through the end of this year. And so we see the margins starting to realign themselves to the 20% full year and start to move forward, as we go into '13, to 21% and 22% gross margin.
I don't know if that's helpful.
Operator
Our next question comes from the line of Robert Kelly with Sidoti & Company.
Robert Kelly
The West Coast consolidation business merger, were there any disruptions there that caused sales pressures and caused some share loss? Anything like that exacerbating the cost issues that you're running through on the West Coast?
Henning Kornbrekke
Yes. When we were going through the restructuring initially.
We did have problems with delivery, particularly on the wholesale side of our business. But fortunately, our folks got very much in line with the issue and did resolve it.
That was an early second quarter issue, and that's been since resolved, and they're now back up, providing outstanding levels of service as we go forward.
Robert Kelly
So that's a potential benefit for the second half of the year?
Henning Kornbrekke
Absolutely, absolutely. And we're starting to get that business back.
We're staying very we close to that, so as we move forward, that business has continued to get stronger.
Robert Kelly
Okay, great. And then just as far as what you see for the second half of the year, is it a function of the res and the non-res business weakening or a deceleration in the positive pockets of industrial infrastructure that you've seen in the first half of the year?
Henning Kornbrekke
I think at this point, I think everyone in -- we talk to our customers, everyone sees the business going pretty much at the pace it's at right now. I think everyone has got their fingers crossed, hoping that the pent-up demand eventually moves forward and starts to impact the business as early as the latter third quarter and fourth quarter of this year.
Robert Kelly
And that's across all your industry verticals, or...
Henning Kornbrekke
I think we'd say in all the businesses we have. We looked at the industry piece that we're in, the commercial piece, the residential, and I think they're all moving in the same direction.
If you look at LIRA -- and I don't know if Ken outlined it, but LIRA suggests that particularly third and fourth quarter this year is to be unusually strong with strong double digits going into the first quarter of 2013. So LIRA is very optimistic on remodeling as we go through the back half of this year and early into the first quarter next year.
And again, that report we just released about 2 or 3 weeks ago, but -- and they were extremely bullish on the back half of this year, particularly going into the first quarter next year.
Brian Lipke
I think too, Robert -- this is Brian. Our commentary is based on 2 relative points.
One, the expectation levels coming into the year, so when we say things have weakened, it's relative to those expectation levels. And the first quarter, I think, it's fairly well established that because of weather conditions and other factors, there was some pull ahead of ordering patterns.
And so off of that level, it has weakened some. But as Henning pointed out, overall, we expect a fairly consistent pattern of low-level activity going on through the balance of the year.
Henning Kornbrekke
I mean on balance, we think we've done a good job. We've had 5.2% growth.
We expected 7% or 8%. There've been a lot of mitigating factors that have pulled back.
But I think we've stayed very aggressive in the marketplace, and we've continued to show growth, in spite of the challenges that we've had. And I think we continue to stay optimistic as we go forward through the year and into 2013.
Robert Kelly
Great. And not to put words in your mouth, but it but sounds like you saw a pretty solid spring, a downshift in May or maybe early June, and you expect that kind of June run rate to play out for the balance of the year?
Henning Kornbrekke
We're still hoping that there's a more positive uptick, as we get into the back end of the third and early fourth quarter.
Brian Lipke
But we'll go with your statement.
Robert Kelly
You're implying 0% flat growth for the second half of the year. I mean, is that how we should think about kind of just a steady run rate from what we've seen here in June?
Brian Lipke
Yes.
Robert Kelly
Okay. Fair enough.
Brian Lipke
While we're frustrated with the slow pace of return to a normality in our end markets, whatever the new normal will be, all it really does is heighten our activity level relative to continuing to find ways to take cost out of the business, find ways to grow organically by producing new and different products, and we have a number of activities underway in that area, strengthening our desire to go out there and find better ways to serve the customers and gain more market share, and then to look for acquisitions that can meaningful help us -- meaningfully help us improve our overall operating performance characteristics, while growing the bottom line. It's frustrating.
We had higher hopes for this year coming into the year based on the estimates that were coming out from the various sources. And it's frustrating that it hasn't developed quicker.
Nonetheless, we are continuing to focus on how we can generate improved performance from our business in the market conditions that we're facing today. And that's why, we emphasized several times during the call that in spite of all of this, our expectation is to generate improved profitability in 2012 over what we saw in 2011 in spite of the fact that the end markets have not improved.
Henning Kornbrekke
And we do have growth initiatives in place, and they have taken longer to finalize but they're still there. And I'll leave it at that.
Robert Kelly
Okay, fair enough. And that kind of segues to my next question, which is the raw material story is kind of masking a lot of the business improvements you've made.
And it's somewhat counterintuitive, because year-over-year, material costs are down, and that's negatively impacting your margin. So with raw materials, your inventory base, I'm guessing lower than it was a year ago and signs that the scrap market is turning positive for August, September.
Does that now become a benefit to the gross margin?
Henning Kornbrekke
I mean, it should. I mean, if you look at the report that came out yesterday, I think hot roll was up $34 a ton for the first time, and they're talking about another $34 a ton next month, so we're kind of looking at that one carefully.
But typically, we do see some improvement, but we try to mitigate those variations in our operations so that we can provide more stable outcomes.
Brian Lipke
You're right though, Robert, it is counterintuitive. The logical thought process would be, oh, if raw material costs come down, your profitability goes up, and that's not always the case.
Some of our businesses track the ups and downs in raw material cost very closely and have a direct impact on sales volume as well. As raw material costs come down and those products where the customers, particularly service centers, track steel prices very closely, they're pretty quick to say, "Okay, your raw material cost has just come down, so your selling price should come down."
So embedded in our dollars sales numbers are the impact of raw material costs. Although fortunately, we have been able to offset some of that through volume increases that are masked by the lower dollar selling prices for some of the products, so it's counterintuitive.
But our whole focus here is to manage the entire supply chain, so that we are mitigating by our various buying practices, the volatility in raw material cost. This year though, we're expecting that raw material cost volatility will be less than what it was last year and puts us in a better position to mitigate against that.
I don't know if that helped or not.
Robert Kelly
Yes, I understand the thought process behind it, but I mean, you're calling out half of your gross margin compression in 2Q due to price cost. I mean, I don't know how that translates to a full year improvement.
But just let me get to the final one. The free cash flow guidance, I mean, the math works out to about $810 million in sales based on the 2% organic and $30 million in acquisition.
So it's $30 million plus for free cash flow for the year. I understand you took your CapEx budget down about $5 million -- $4 million to $5 million compared to what you said on 2Q, but where -- how do we get from a $6 million outflow through the second quarter to plus $30 million for the year for 2012?
Kenneth Smith
A lot of that'll be driven by the recouping of the working capital investment that we made the front half of the year.
Robert Kelly
So you'll be plus $50 million on working capital for the second half of the year, something along those lines?
Kenneth Smith
I don't have the numbers right in front of me. But we do recoup a significant amount of what we've invested.
Robert Kelly
Okay. Do you...
Brian Lipke
Keep in mind what we do, Robert, is we build inventory for the strong selling season during the first quarter, and then we pull it back down over the second, third and fourth quarters. And that's an annual pattern.
Robert Kelly
Right. So I mean, are you getting a little bit -- with the changes on the West Coast, I mean, are you getting a little more efficient with working capital, is that kind of the implication?
Henning Kornbrekke
Absolutely.
Brian Lipke
And that's where our biggest opportunity to get more efficient with working capital lies.
Henning Kornbrekke
Particularly inventory.
Robert Kelly
And that shows up in the second half of the year?
Brian Lipke
Yes.
Operator
Our next question comes from the line with the Tim Hayes with Davenport & Company.
Timothy Hayes
Just one follow-up, and I think you just answered it in the last question here, but you mentioned pricing pressure across all end markets. I was curious if there was a -- if any parts of your channel were showing more competition like distribution over retail, figuring that service centers were pulling back as they saw commodity prices pull back.
So was there more price competition in the distribution channel versus retail? Would that be a fair...
Henning Kornbrekke
We start an awful lot at retail, I think, more than usual at retail, as we went through the quarter. And we did see more on the industrial.
And I think the industrial pricing was a function of the low market demand. And I think those customers, those competitors that we have simply were using pricing to gain what business was out there.
And that was primarily, I think -- we think a second quarter event. I think as we came out of the end of July, it looked like we were starting to see some improvement there, which was positive.
Timothy Hayes
That's on the industrial side only?
Henning Kornbrekke
Yes, that was on the industrial side.
Operator
There are no further questions at this time. I'd like to hand the floor back over to Mr.
Lipke for closing comments.
Brian Lipke
Thank you for joining us on the call today. I assure you that we are working very hard on all the areas of the business to improve our profitability, in spite of difficult and continuing difficult end market conditions.
And we look forward to reporting back to you next quarter on our continued progress. Thank you.
Operator
Ladies and gentlemen, thank you very much for your participation in today's conference call. You may now disconnect your lines, and have a wonderful day.