TopBuild Corp - Quarter Report: 2018 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE

COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


(Mark One)
☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018


☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 1-36870

TopBuild Corp.

(Exact name of Registrant as Specified in its Charter)

Delaware

(State or Other Jurisdiction of Incorporation or
Organization)

47-3096382

(I.R.S. Employer
Identification No.)

475 North Williamson Boulevard

Daytona Beach, Florida

(Address of Principal Executive Offices)

32114

(Zip Code)

(386) 304-2200

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). ☒ Yes ☐ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☒ Accelerated filer ☐ Smaller reporting company ☐ Non-accelerated filer ☐ Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class		Shares Outstanding at October 31, 2018
Common stock, par value $0.01 per share		35,384,990

Table of Contents

TOPBUILD CORP.

TABLE OF CONTENTS


		Page No.
Part I.	Financial Information

Item 1.	Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets	4

	Condensed Consolidated Statements of Operations	5

	Condensed Consolidated Statements of Cash Flows	6

	Condensed Consolidated Statements of Changes in Equity	7

	Notes to Condensed Consolidated Financial Statements	8

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	27

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	37

Item 4.	Controls and Procedures	37

Part II.	Other Information

Item 1.	Legal Proceedings	38

Item 1A.	Risk Factors	38

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	40

Item 3.	Defaults upon Senior Securities	40

Item 4.	Mine Safety Disclosures	40

Item 5.	Other Information	40

Item 6.	Exhibits	40

Index to Exhibits		41

Signature		42

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GLOSSARY

We use acronyms, abbreviations, and other defined terms throughout this quarterly report on Form 10-Q, which are defined in the glossary below:


Term		Definition
2015 LTIP		2015 TopBuild Long-Term Incentive Plan, as amended from time to time
2016 Repurchase Program		$50 million share repurchase program authorized by the Board on March 1, 2016
2017 ASR Agreement		$100 million accelerated share repurchase agreement with Bank of America, N.A.
2017 Repurchase Program		$200 million share repurchase program authorized by the Board on February 24, 2017
ADO		ADO Products, LLC
Amended Credit Agreement		Senior secured credit agreement and related security and pledge agreement dated May 5, 2017, as amended March 28, 2018, with the Lenders
Annual Report		Annual report filed with the SEC on Form 10-K pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
ASC		Accounting Standards Codification
ASU		Accounting Standards Update
Board		The Board of Directors of TopBuild Corp.
BofA		Bank of America, N.A.
Canyon		Canyon Insulation, Inc.
Capital		Capital Insulation, Inc.
EBITDA		Earnings before income taxes, depreciation, and amortization
EcoFoam		Bella Insulutions Inc., DBA EcoFoam/Insulutions
ETR		Effective tax rate
Exchange Act		The Securities Exchange Act of 1934, as amended
FASB		Financial Accounting Standards Board
FCCR		Fixed charge coverage ratio is defined in the “Amended Credit Agreement” as the ratio of EBITDA less capital expenditures, and income taxes paid to the sum of cash interest paid, debt principal payments and restricted payments made excluding stock repurchases
GAAP		Generally accepted accounting principles in the United States of America
Guarantors		All wholly-owned domestic subsidiaries of TopBuild Corp.
Lenders		Bank of America, N.A., together with the other lenders party to the "Amended Credit Agreement"
LIBOR		London interbank offered rate
Midwest		Midwest Fireproofing, LLC
MR Insulfoam		MR Insulfoam, LLC
Net Leverage Ratio		As defined in the “Amended Credit Agreement,” the ratio of outstanding indebtedness, less up to $75 million of unrestricted cash, to EBITDA
NYSE		New York Stock Exchange
Old Credit Agreement		Senior secured credit agreement, as amended, and related collateral and guarantee documentation dated June 9, 2015, with PNC Bank, N.A. as administrative agent, and the other lenders and agents party thereto
Options		Stock option awards
Owens Corning		Owens Corning Sales, LLC
Quarterly Report		Quarterly report filed with the SEC on Form 10-Q pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Revolving Facility		Senior secured revolving credit facilities available under the credit agreements. With respect to the Old Credit Agreement, a $125 million facility with applicable sublimits for letters of credit and swingline loans. With respect to the Amended Credit Agreement, a $250 million facility with applicable sublimits for letters of credit and swingline loans.
RSA		Restricted stock award
Santa Rosa		Santa Rosa Insulation and Fireproofing, LLC
SEC		United States Securities and Exchange Commission
Secured Leverage Ratio		As defined in the “Amended Credit Agreement,” the ratio of outstanding indebtedness, including letters of credit, to EBITDA
Senior Notes		TopBuild's 5.625% senior unsecured notes due on May 1, 2026
Superior		Superior Insulation Products, LLC
TopBuild		TopBuild Corp. and its wholly-owned consolidated domestic subsidiaries. Also, the "Company," "we," "us," and "our"
TTM		Trailing twelve months
USI		United Subcontractors, Inc.

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PART I – FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

TOPBUILD CORP.

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(In thousands except share data)


	As of
	September 30,		December 31,
	2018		2017
ASSETS
Current assets:
Cash and cash equivalents	$	93,463	$	56,521
Receivables, net of an allowance for doubtful accounts of $4,929 and $3,673 at September 30, 2018, and December 31, 2017, respectively		419,706		308,508
Inventories, net		161,875		131,342
Prepaid expenses and other current assets		24,074		15,221
Total current assets		699,118		511,592

Property and equipment, net		166,748		107,121
Goodwill		1,362,747		1,077,186
Other intangible assets, net		205,103		33,243
Deferred tax assets, net		17,634		18,129
Other assets		5,476		2,278
Total assets	$	2,456,826	$	1,749,549

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	300,938	$	263,814
Current portion of long-term debt - term loan		19,688		12,500
Current portion of long-term debt - equipment notes		3,754		—
Accrued liabilities		116,243		75,087
Total current liabilities		440,623		351,401

Long-term debt - term loan		309,548		229,387
Long-term debt - equipment notes		15,128		—
Long-term debt - Senior Notes		393,769		—
Deferred tax liabilities, net		167,508		132,840
Long-term portion of insurance reserves		42,347		36,160
Other liabilities		1,868		3,242
Total liabilities		1,370,791		753,030

Commitments and contingencies

Equity:
Preferred stock, $0.01 par value: 10,000,000 shares authorized; 0 shares issued and outstanding at September 30, 2018, and December 31, 2017		—		—
Common stock, $0.01 par value: 250,000,000 shares authorized; 38,689,305 issued and 35,493,406 outstanding at September 30, 2018, and 38,626,378 shares issued and 35,586,916 outstanding at December 31, 2017		387		386
Treasury stock, 3,195,899 shares at September 30, 2018, and 3,039,462 shares at December 31, 2017, at cost		(171,075)		(141,582)
Additional paid-in capital		853,410		830,600
Retained earnings		403,313		307,115
Total equity		1,086,035		996,519
Total liabilities and equity	$	2,456,826	$	1,749,549

See notes to our unaudited condensed consolidated financial statements.

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TOPBUILD CORP.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(In thousands except share and per common share data)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Net sales	$	647,289	$	489,044	$	1,744,702	$	1,404,865
Cost of sales		485,424		368,205		1,326,777		1,065,789
Gross profit		161,865		120,839		417,925		339,076

Selling, general, and administrative expense (exclusive of significant legal settlement, shown separately below)		95,648		71,277		274,134		222,181
Significant legal settlement		—		—		—		30,000
Operating profit		66,217		49,562		143,791		86,895

Other income (expense), net:
Interest expense		(9,381)		(2,479)		(19,026)		(5,767)
Loss on extinguishment of debt		—		—		—		(1,086)
Other, net		178		27		292		239
Other expense, net		(9,203)		(2,452)		(18,734)		(6,614)
Income before income taxes		57,014		47,110		125,057		80,281

Income tax expense		(14,356)		(15,717)		(28,859)		(27,139)
Net income	$	42,658	$	31,393	$	96,198	$	53,142

Income per common share:
Basic	$	1.22	$	0.90	$	2.74	$	1.47
Diluted	$	1.19	$	0.88	$	2.69	$	1.44

Weighted average shares outstanding:
Basic		35,091,388		35,022,113		35,084,694		36,203,497
Diluted		35,789,383		35,737,629		35,815,357		36,842,144

See notes to our unaudited condensed consolidated financial statements.

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TOPBUILD CORP.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(In thousands)


	Nine Months Ended September 30,
	2018		2017
Cash Flows Provided by (Used in) Operating Activities:
Net income	$	96,198	$	53,142
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		27,133		11,753
Share-based compensation		8,244		7,473
Loss on extinguishment of debt		—		1,086
Loss on sale or abandonment of property and equipment		764		614
Amortization of debt issuance costs		812		293
Change in fair value of contingent consideration		(373)		98
Provision for bad debt expense		3,003		2,498
Loss from inventory obsolescence		1,375		1,390
Deferred income taxes, net		(708)		266
Change in certain assets and liabilities
Receivables, net		(46,993)		(43,931)
Inventories, net		(15,333)		249
Prepaid expenses and other current assets		(5,560)		8,362
Accounts payable		17,768		(2,280)
Accrued liabilities		10,304		13,633
Other, net		(601)		(28)
Net cash provided by operating activities		96,033		54,618

Cash Flows Provided by (Used in) Investing Activities:
Purchases of property and equipment		(42,379)		(13,088)
Acquisition of businesses, net of cash acquired of $15,756 in 2018		(500,666)		(84,040)
Proceeds from sale of property and equipment		502		453
Other, net		31		178
Net cash used in investing activities		(542,512)		(96,497)

Cash Flows Provided by (Used in) Financing Activities:
Proceeds from issuance of Senior Notes		400,000		—
Proceeds from issuance of term loan		100,000		250,000
Repayment of term loan		(11,875)		(183,125)
Proceeds from equipment notes		20,104		—
Repayment of equipment notes		(1,222)		—
Proceeds from revolving credit facility		90,000		170,000
Repayment of revolving credit facility		(90,000)		(165,000)
Payment of debt issuance costs		(7,819)		(2,150)
Taxes withheld and paid on employees' equity awards		(5,433)		(4,475)
Repurchase of shares of common stock		(9,493)		(139,286)
Payment of contingent consideration		(841)		—
Net cash provided by (used in) financing activities		483,421		(74,036)

Cash and Cash Equivalents
Increase (decrease) for the period		36,942		(115,915)
Beginning of year		56,521		134,375
End of period	$	93,463	$	18,460

Supplemental disclosure of noncash investing activities:
Accruals for property and equipment	$	546	$	154

See notes to our unaudited condensed consolidated financial statements.

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TOPBUILD CORP.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (Unaudited)

(In thousands except share data)


	Common		Treasury		Additional
	Stock		Stock		Paid-in		Retained
	($0.01 par value)		at cost		Capital		Earnings		Equity
Balance at December 31, 2016	$	385	$	(22,296)	$	845,476	$	148,982	$	972,547
Net income		—		—		—		53,142		53,142
Share-based compensation		—		—		7,473		—		7,473
Issuance of 158,900 restricted share awards under long-term equity incentive plan		1		—		(1)		—		—
Repurchase of 858,393 shares of common stock pursuant to 2016 and 2017 Repurchase Programs		—		(39,286)		—		—		(39,286)
Repurchase of 1,507,443 shares of common stock pursuant to the 2017 ASR Agreement		—		(80,000)		(20,000)		—		(100,000)
113,087 shares of common stock withheld to pay taxes on employees' equity awards		—		—		(4,475)		—		(4,475)
Balance at September 30, 2017	$	386	$	(141,582)	$	828,473	$	202,124	$	889,401

Balance at December 31, 2017	$	386	$	(141,582)	$	830,600	$	307,115	$	996,519
Net income		—		—		—		96,198		96,198
Share-based compensation		—		—		8,244		—		8,244
Issuance of 90,760 restricted share awards under long-term equity incentive plan		1		—		(1)		—		—
Repurchase of 142,780 shares of common stock pursuant to 2017 Repurchase Program		—		(9,493)		—		—		(9,493)
Repurchase of 13,657 shares of common stock pursuant to the settlement of the 2017 ASR Agreement		—		(20,000)		20,000		—		—
97,429 shares of common stock withheld to pay taxes on employees' equity awards		—		—		(5,433)		—		(5,433)
Balance at September 30, 2018	$	387	$	(171,075)	$	853,410	$	403,313	$	1,086,035

See notes to our unaudited condensed consolidated financial statements.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

1. BASIS OF PRESENTATION

TopBuild is a Delaware corporation incorporated on June 30, 2015, and is listed on the NYSE under the ticker symbol “BLD.” We report our business in two segments: Installation and Distribution. Our Installation segment primarily installs insulation and other building products. Our Distribution segment primarily sells and distributes insulation and other building products. Our segments are based on our operating units, for which financial information is regularly evaluated by our corporate operating executives.

In our opinion, the accompanying unaudited condensed consolidated financial statements contain all adjustments, of a normal recurring nature, necessary to state fairly our financial position as of September 30, 2018, our results of operations for the three and nine months ended September 30, 2018 and 2017, and cash flows for the nine months ended September 30, 2018 and 2017. The Condensed Consolidated Balance Sheet at December 31, 2017, was derived from our audited financial statements, but does not include all disclosures required by GAAP.

These condensed consolidated financial statements and related notes should be read in conjunction with the audited Consolidated Financial Statements included in the Company’s Annual Report for the year ended December 31, 2017.

2. ACCOUNTING POLICIES

Financial Statement Presentation. Our condensed consolidated financial statements have been developed in conformity with GAAP, which requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosures of contingent liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from these estimates. All intercompany transactions between TopBuild entities have been eliminated.

Business Combinations. The purchase price for business combinations is allocated to the estimated fair values of acquired tangible and intangible assets, including goodwill, and assumed liabilities, where applicable. Additionally, we recognize customer relationships, trademarks and trade names, and non-competition agreements as identifiable intangible assets. These assets are recorded at fair value as of the transaction date. The fair value of these intangible assets is determined primarily using the income approach and using current industry information. Goodwill is recorded when consideration transferred exceeds the fair value of identifiable assets and liabilities. Measurement-period adjustments are recorded in the period they occur. Contingent consideration is recorded at fair value at the acquisition date.

Share-based Compensation. Our share-based compensation program currently consists of RSAs and Options. Share-based compensation expense is reported in selling, general, and administrative expense. We do not capitalize any compensation cost related to share-based compensation awards. The income tax benefits and deficiencies associated with share-based awards are reported as a component of income tax expense. Excess tax benefits and deficiencies are included in net cash provided by (used in) operating activities while shares withheld for tax-withholding are reported in financing activities under the caption “Taxes withheld and paid on employees’ equity awards” in our Condensed Consolidated Statements of Cash Flows. Award forfeitures are accounted for in the period they occur.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following table details our award types and accounting policies:


Award Type:	Fair Value Determination	Vesting	Expense Recognition‡	Expense Measurement
Restricted Share Awards
Service Condition	Closing stock price on date of grant	Ratably; 3 or 5 years	Straight-line	Fair value at grant date
Performance Condition	Closing stock price on date of grant	Cliff; 3 years	Straight-line; Adjusted based on meeting or exceeding performance targets	Evaluated quarterly; 0 - 200% of fair value at grant date depending on performance
Market Condition	Monte-Carlo Simulation	Cliff; 3 years	Straight-line; Recognized even if condition is not met	Fair value at grant date
Stock Options†	Black-Scholes Options Pricing Model	Ratably; 3 or 5 years	Straight-line	Fair value at grant date

†Stock options expire no later than 10 years after the grant date.

‡Expense is reversed if award is forfeited prior to vesting.

Recently Adopted Accounting Pronouncements:

In May 2014 the FASB issued a new standard for revenue recognition, ASC 606. Subsequent to issuing ASC 606, the FASB issued a number of updates and technical improvements which do not change the core principles of the guidance. The purpose of ASC 606 is to provide a single, comprehensive revenue recognition model for all contracts with customers to improve comparability across industries. Effective January 1, 2018, we adopted ASC 606 using the modified retrospective approach. Adoption of this standard did not have a material impact on our financial position or results of operations for any periods presented. As such, a cumulative adjustment was not recorded to our beginning retained earnings balance.

Revenue Recognition

Revenue is disaggregated between our Installation and Distribution segments. A reconciliation of disaggregated revenue by segment is included in Note 6 – Segment Information.

We recognize revenue for our Installation segment using the percentage of completion method of accounting with respect to each particular order within a given customer’s contract, based on the amount of material installed at that customer’s location and the associated labor costs, as compared to the total expected cost for the particular order. Revenue is recognized over time as the customer is able to receive and utilize the benefits provided by our services. Each contract contains one or more individual orders, which are based on services delivered. When a contract modification is made, typically the remaining goods or services are considered distinct and we recognize revenue for the modification as a separate performance obligation. When insulation and installation services are bundled in a contract, we combine these items into one performance obligation as the overall promise is to transfer the combined item.

Revenue from our Distribution segment is recognized when title to products and risk of loss transfers to our customers. This represents the point in time when the customer is able to direct the use of and obtain substantially all the benefits from the product. The determination of when control is deemed transferred depends on the shipping terms that are agreed upon in the contract.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

At time of sale, we record estimated reductions to revenue for customer programs and incentive offerings, including special pricing and other volume-based incentives based on historical experience, which is continuously adjusted. The duration of our contracts with customers is relatively short, generally less than a 90-day period, therefore there is not a significant financing component when considering the determination of the transaction price which gets allocated to the individual performance obligations, generally based on standalone selling prices. Additionally, we consider shipping costs charged to a customer as a fulfillment cost rather than a promised service and expense as incurred. Sales taxes, when incurred, are recorded as a liability and excluded from revenue on a net basis.

We record a contract asset when we have satisfied our performance obligation prior to billing and a contract liability generally when a customer payment is received prior to the satisfaction of our performance obligation. The difference between the beginning and ending balances of our contract assets and liabilities primarily results from the timing of our performance and the customer’s payment.

The following table represents our contract assets and contract liabilities with customers, in thousands:


	Included in Line Item on		As of
	Condensed Consolidated	September 30,		December 31,
	Balance Sheets	2018		2017
Contract Assets:
Receivables, unbilled	Receivables, net	$	58,755	$	37,142

Contract Liabilities:
Deferred revenue	Accrued liabilities	$	19,782	$	9,275

The increase in our contract asset and contract liability balances from December 31, 2017 is primarily a result of the USI acquisition. Our contract liabilities are normally recognized to net sales in the immediately subsequent reporting period due to the generally short-term nature of our contracts with customers.

In August 2016 the FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments”. This standard addresses the diversity in practice of how certain cash receipts and payments are classified in the statement of cash flows, including contingent consideration payments made after a business combination which is relevant for us. This update was effective for us beginning January 1, 2018, and we adopted the standard using a retrospective approach. There was no impact to any prior periods.

In January 2017 the FASB issued ASU 2017-01, “Clarifying the Definition of a Business.” The new standard narrows the definition of a business and provides a framework for evaluation. This update was effective for us beginning January 1, 2018, and we adopted the standard using a prospective approach. The adoption of this standard did not have a material impact on our financial position or results of operations.

Recently Issued Accounting Pronouncements Not Yet Adopted:

In February 2016 the FASB issued ASU 2016-02, “Leases.” This standard requires a lessee to recognize most leases on its balance sheet. Companies are required to use a modified retrospective transition method for all existing leases. This standard is effective for annual periods beginning after December 15, 2018, and interim periods therein with early adoption permitted. We plan to adopt this guidance on January 1, 2019. We have identified substantially all of our contracts that fall within the scope of this guidance and are finalizing our evaluation of the impact of adoption on our financial position and results of operations.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

In June 2016 the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses”. This guidance introduces a current expected credit loss (“CECL”) model for the recognition of impairment losses on financial assets, including trade receivables. The CECL model replaces current GAAP’s incurred loss model. Under CECL, companies will record an allowance through current earnings for the expected credit loss for the life of the financial asset upon initial recognition of the financial asset. This update is effective for us at the beginning of 2020 with early adoption permitted at the beginning of 2019. We have not yet selected an adoption date, and we are currently evaluating the effect of adoption of this standard on our financial position and results of operations.

In January 2017 the FASB issued ASU 2017-04, “Simplifying the Test for Goodwill Impairment.” The new standard simplifies the subsequent measurement of goodwill by eliminating the second step of the goodwill impairment test. This update is effective for us beginning January 1, 2020. Early adoption is permitted and the new standard will be applied on a prospective basis. We have not yet selected an adoption date, and we are currently evaluating the effect of adoption of this standard on our financial position and results of operations.

In August 2018 the FASB issued ASU 2018-13, “Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement.” The new standard modifies the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement, including adjustments to Level 3 fair value measurement disclosures as well as the removal of disclosures around Level 1 and Level 2 transfers. This update is effective for us beginning January 1, 2020. Early adoption is permitted and the new standard will be applied on a prospective basis. We have not yet selected an adoption date, and we are currently evaluating the effect of adoption of this standard on our financial position and results of operations.

3. GOODWILL AND OTHER INTANGIBLES

We have two reporting units which are also our operating and reporting segments: Installation and Distribution. Both reporting units contain goodwill. Assets acquired and liabilities assumed are assigned to the applicable reporting unit based on whether the acquired assets and liabilities relate to the operations of and determination of the fair value of such unit. Goodwill assigned to the reporting unit is the excess of the fair value of the acquired business over the fair value of the individual assets acquired and liabilities assumed for the reporting unit.

The estimated fair values of the two reporting units substantially exceeded their respective carrying values.

Changes in the carrying amount of goodwill for the nine months ended September 30, 2018, by segment, were as follows, in thousands:


	Gross Goodwill				Gross Goodwill		Accumulated		Net Goodwill
	at				at		Impairment		at
	December 31, 2017		Additions		September 30, 2018		Losses		September 30, 2018
Goodwill, by segment:
Installation	$	1,422,920	$	255,465	$	1,678,385	$	(762,021)	$	916,364
Distribution		416,287		30,096		446,383		—		446,383
Total goodwill	$	1,839,207	$	285,561	$	2,124,768	$	(762,021)	$	1,362,747

The following table sets forth our other intangible assets, in thousands:


	As of
	September 30,		December 31,
	2018		2017
Gross definite-lived intangible assets	$	219,382	$	54,872
Accumulated amortization		(14,279)		(21,629)
Net definite-lived intangible assets	$	205,103	$	33,243

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following table sets forth a breakout of our intangible assets as of September 30, 2018, in thousands:


	Gross Definite‑lived Intangible Assets		Accumulated Amortization		Net Definite‑lived Intangible Assets
Trademarks and trade names	$	13,435	$	(979)	$	12,456
Customer relationships		198,428		(11,401)		187,027
Non-competition agreements		7,519		(1,899)		5,620
Total	$	219,382	$	(14,279)	$	205,103

The following table sets forth our amortization expense, in thousands:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Amortization expense	$	5,242	$	1,516	$	10,536	$	1,955

4. LONG-TERM DEBT

On May 5, 2017, we and the Guarantors entered into a credit agreement with the Lenders. All obligations under the credit agreement are guaranteed by the Guarantors, and all obligations under the credit agreement, including the guarantees of those obligations, are secured by substantially all of the assets of us and the Guarantors.

On March 28, 2018, we executed an amendment to our credit agreement, which primarily facilitated the acquisition of USI by (i) extending until August 29, 2018, the period during which the Company could access the $100.0 million delayed draw term loan feature and (ii) providing that the Company could issue up to $500.0 million of Senior Notes in connection with its acquisition of USI. On May 1, 2018, we closed on our acquisition of USI. The acquisition was funded through net proceeds from the issuance on April 25, 2018, of $400.0 million of 5.625% Senior Notes due in 2026 together with the net proceeds from the $100.0 million delayed draw term loan commitment accessed on May 1, 2018, under our Amended Credit Agreement. These funds were also used for the payment of related fees and expenses, as well as for general corporate purposes.

The Senior Notes are our senior unsecured obligations and bear interest at 5.625% per year, payable semiannually in arrears on May 1 and November 1 of each year, beginning on November 1, 2018. The Senior Notes mature on May 1, 2026, unless redeemed early or repurchased. We have the right to redeem the Senior Notes under certain circumstances, and, if we undergo a change in control, we must make an offer to repurchase all of the Senior Notes then outstanding at a repurchase price equal to 101% of their aggregate principal amount, plus accrued and unpaid interest (if any) to, but not including, the repurchase date.

Interest payable on borrowings under the Amended Credit Agreement is based on an applicable margin rate plus, at our option, either:

A base rate determined by reference to the highest of either (i) the federal funds rate plus 0.50 percent, (ii) Bank of America’s “prime rate,” or (iii) the LIBOR rate for U.S. dollar deposits with a term of one month, plus 1.00 percent; or

A LIBOR rate determined by reference to the costs of funds for deposits in U.S. dollars for the interest period relevant to such borrowings.

The applicable margin rate is determined based on our Secured Leverage Ratio. In the case of base rate borrowings, the applicable margin rate ranges from 0.00 percent to 1.50 percent and in the case of LIBOR rate borrowings, the applicable margin ranges from 1.00 percent to 2.50 percent.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

We are required to pay commitment fees to the Lenders in respect of any unutilized commitments. The commitment fees range from 0.15 percent to 0.275 percent per year, depending on our Secured Leverage Ratio. We must also pay customary fees on outstanding letters of credit.

The following table outlines the key terms of our Amended Credit Agreement, dollars in thousands:


Senior secured term loan facility (original borrowing) (a)	$	250,000
Additional delayed draw term loan (b)	$	100,000

Additional term loan and/or revolver capacity available under incremental facility (c)	$	200,000

Revolving Facility	$	250,000
Sublimit for issuance of letters of credit under Revolving Facility (d)	$	100,000
Sublimit for swingline loans under Revolving Facility (d)	$	20,000

Interest rate as of September 30, 2018		3.33	%
Scheduled maturity date		5/05/2022

(a)

The Amended Credit Agreement provides for a term loan limit of $350.0 million; $250.0 million was drawn on May 5, 2017.

(b)

On May 1, 2018, the net proceeds from the $100.0 million delayed draw term loan were used to partially fund the USI acquisition.

(c)

Additional borrowing capacity is available under the incremental facility, subject to certain terms and conditions (including existing or new lenders providing commitments in respect of such additional borrowing capacity).

(d)

Use of the sublimits for the issuance of letters of credit and swingline loans reduces the availability under the Revolving Facility.

Borrowings under the Amended Credit Agreement are prepayable at the Company’s option without premium or penalty. The Company is required to make prepayments with the net cash proceeds of certain asset sales and certain extraordinary receipts.

Beginning in the first quarter of 2018, the Company executed various equipment notes for the purpose of financing the purchase of vehicles and equipment. The following table summarizes equipment notes entered into during the respective periods, in thousands:


	Three Months Ended September 30, 2018		Nine Months Ended September 30, 2018
Equipment notes	$	5,038	$	20,104

The following table sets forth our remaining principal payments for our outstanding Senior Notes, term loan and equipment notes as of September 30, 2018, in thousands:


	Payments Due by Period
	2018		2019		2020		2021		2022		Thereafter		Total
Senior Notes	$	—	$	—	$	—	$	—	$	—	$	400,000	$	400,000
Term loan		4,375		21,875		26,250		30,625		248,750		—		331,875
Equipment notes		928		3,788		3,945		4,110		4,281		1,830		18,882
Total	$	5,303	$	25,663	$	30,195	$	34,735	$	253,031	$	401,830	$	750,757

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following table reconciles the principal balance of our outstanding debt to our Condensed Consolidated Balance Sheets, in thousands:


	As of
	September 30,		December 31,
Principal debt balances:	2018		2017
Current portion of long-term debt - term loan	$	19,688	$	12,500
Current portion of long-term debt - equipment notes		3,754		—
Long-term portion of long-term debt - Senior Notes		400,000		—
Long-term portion of long-term debt - term loan		312,187		231,250
Long-term portion of long-term debt - equipment notes		15,128		—
Unamortized debt issuance costs		(8,870)		(1,863)
Total net debt	$	741,887	$	241,887

The Company has outstanding standby letters of credit that secure our financial obligations related to our workers’ compensation, general insurance, and auto liability programs. These standby letters of credit, as well as any outstanding amount borrowed under our revolving credit facility, reduce the availability under the Revolving Facility. The following table summarizes our availability under the Revolving Facility, in thousands:


	As of
	September 30,		December 31,
	2018		2017
Revolving Facility	$	250,000	$	250,000
Less: standby letters of credit		(59,288)		(47,055)
Capacity under Revolving Facility	$	190,712	$	202,945

The indenture governing our Senior Notes contains customary restrictive covenants that, among other things, generally limit our ability to incur additional debt and issue preferred stock; to create liens; to pay dividends, acquire shares of capital stock, make payments on subordinated debt or make investments; to place limitations on distributions from certain subsidiaries; to issue guarantees; to issue or sell the capital stock of certain subsidiaries; to sell assets; to enter into transactions with affiliates; and to effect mergers. The Senior Notes indenture also contains customary events of default, subject in certain cases to grace and cure periods. Generally, if an event of default occurs and is continuing, the trustee under the indenture or the holders of at least 25% in aggregate principal amount of the Senior Notes then outstanding may declare the principal of, premium, if any, and accrued interest on all the Senior Notes immediately due and payable. The Senior Notes and related guarantees have not been registered under the Securities Act of 1933, and we are not required to register either the Senior Notes or the guarantees in the future.

The Amended Credit Agreement contains certain covenants that limit, among other things, the ability of the Company to incur additional indebtedness or liens; to make certain investments or loans; to make certain restricted payments; to enter into consolidations, mergers, sales of material assets, and other fundamental changes; to transact with affiliates; to enter into agreements restricting the ability of subsidiaries to incur liens or pay dividends; or to make certain accounting changes. The Amended Credit Agreement contains customary affirmative covenants and events of default.

The Amended Credit Agreement requires us to maintain a Net Leverage Ratio and minimum FCCR throughout the term of the agreement. The following table sets forth the maximum Net Leverage Ratios and minimum FCCR:


Quarter Ending	Maximum Net Leverage Ratio	Minimum FCCR
June 30, 2018 through September 30, 2018	3.75:1.00	1.25:1.00
December 31, 2018 through June 30, 2019	3.50:1.00	1.25:1.00
September 30, 2019 and each fiscal quarter end thereafter	3.25:1.00	1.25:1.00

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

We were in compliance with these key financial covenants under the Amended Credit Agreement as of September 30, 2018.

5. FAIR VALUE MEASUREMENTS

The fair value measurement standard defines fair value as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date (referred to as an “exit price”). Authoritative guidance on fair value measurements and disclosures clarifies that a fair value measurement for a liability should reflect the entity’s non-performance risk. In addition, a fair value hierarchy is established that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted market prices in active markets for identical assets and liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).

Fair Value on Recurring Basis

The carrying values of cash and cash equivalents, receivables, net, and accounts payable are considered to be representative of their respective fair values due to the short-term nature of these instruments. We measure our contingent consideration liabilities related to business combinations at fair value. For more information see Note 12 – Business Combinations.

Fair Value on Non-Recurring Basis

Fair value measurements were applied to our long-term debt portfolio. We believe the carrying value of our term loan approximates the fair market value primarily due to the fact that the non-performance risk of servicing our debt obligations, as reflected in our business and credit risk profile, has not materially changed since we assumed our debt obligations under the Amended Credit Agreement. In addition, due to the floating-rate nature of our term loan, the market value is not subject to variability solely due to changes in the general level of interest rates as is the case with a fixed-rate debt obligation. Based on active market trades of our Senior Notes close to September 30, 2018 (Level 1 fair value measurement), we estimate that the fair value of the Senior Notes is approximately $390.0 million compared to a gross carrying value of $400.0 million at September 30, 2018.

During all periods presented, there were no transfers between fair value hierarchical levels.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

6. SEGMENT INFORMATION

The following table sets forth our net sales and operating results by segment, in thousands:


	Three Months Ended September 30,
	2018		2017		2018		2017
	Net Sales				Operating Profit (b)
Our operations by segment were (a):
Installation	$	464,540	$	333,238	$	61,004	$	40,862
Distribution		212,948		181,146		19,229		18,300
Intercompany eliminations		(30,199)		(25,340)		(5,658)		(4,413)
Total	$	647,289	$	489,044		74,575		54,749
General corporate expense, net (d)						(8,358)		(5,187)
Operating profit, as reported						66,217		49,562
Other expense, net						(9,203)		(2,452)
Income before income taxes					$	57,014	$	47,110


	Nine Months Ended September 30,
	2018		2017		2018		2017
	Net Sales				Operating Profit (b)
Our operations by segment were (a):
Installation (exclusive of significant legal settlement, shown separately below)	$	1,223,357	$	945,109	$	139,969	$	96,985
Significant legal settlement (Installation segment) (c)		—		—		—		(30,000)
Distribution		606,335		526,452		57,141		50,806
Intercompany eliminations		(84,990)		(66,696)		(15,382)		(11,393)
Total	$	1,744,702	$	1,404,865		181,728		106,398
General corporate expense, net (d)						(37,937)		(19,503)
Operating profit, as reported						143,791		86,895
Other expense, net						(18,734)		(6,614)
Income before income taxes					$	125,057	$	80,281

(a)

All of our operations are located in the U.S.

(b)

Segment operating profit for the three and nine months ended September 30, 2018 and 2017, includes an allocation of general corporate expenses attributable to the operating segments which is based on direct benefit or usage (such as salaries of corporate employees who directly support the segment).

(c)

Significant legal settlement expense of $30.0 million incurred during the nine months ended September 30, 2017, related to the settlement agreement with Owens Corning. For more information see Note 7 – Other Commitments and Contingencies.

(d)

General corporate expense, net includes expenses not specifically attributable to our segments for functions such as corporate human resources, finance, and legal, including salaries, benefits, and other related costs.

7. OTHER COMMITMENTS AND CONTINGENCIES

Litigation. During the first quarter of 2017, we recognized a $30.0 million expense for a legal settlement with Owens Corning in connection with a breach of contract action related to our termination of an insulation supply contract. Under the terms of the settlement, we paid Owens Corning $30.0 million. The settlement resulted in the dismissal of the lawsuit filed in May 2016 in Toledo, Ohio. The settlement is reflected in the significant legal settlement line item within our Condensed Consolidated Statements of Operations for the nine months ended September 30, 2017. The settlement is also reflected in our installation segment’s operating results for the nine months ended September 30, 2017.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

We are subject to certain claims, charges, litigation, and other proceedings in the ordinary course of our business, including those arising from or related to contractual matters, intellectual property, personal injury, environmental matters, product liability, product recalls, construction defects, insurance coverage, personnel and employment disputes, antitrust, and other matters, including class actions. We believe we have adequate defenses in these matters and we do not believe that the ultimate outcome of these matters will have a material adverse effect on us. However, there is no assurance that we will prevail in any of these pending matters, and we could in the future incur judgments, enter into settlements of claims, or revise our expectations regarding the outcome of these matters, which could materially impact our liquidity and our results of operations.

Other Matters. We enter into contracts which include customary indemnities that are standard for the industries in which we operate. Such indemnities include, among other things, customer claims against builders for issues relating to our products and workmanship. In conjunction with divestitures and other transactions, we occasionally provide customary indemnities relating to various items including, among others: the enforceability of trademarks; legal and environmental issues; and asset valuations. We evaluate the probability that we may incur liabilities under these customary indemnities and appropriately record an estimated liability when deemed probable.

We occasionally use performance bonds to ensure completion of our work on certain larger customer contracts that can span multiple accounting periods. Performance bonds generally do not have stated expiration dates; rather, we are released from the bonds as the contractual performance is completed. Other types of bonds outstanding were principally license and insurance related.

8. INCOME TAXES

Our effective tax rates were 25.2 percent and 23.1 percent for the three and nine months ended September 30, 2018, respectively. The effective tax rates for the three and nine months ended September 30, 2017, were 33.4 percent and 33.8 percent, respectively. The 2018 rates are lower due to the lower Federal tax rate enacted by the Tax Cuts and Jobs Act and the impact of discrete benefits related to share-based compensation, partially offset by State tax adjustments from rate changes related to the USI acquisition and from return to accrual adjustments for tax returns filed in 2018 related to 2017.

A tax benefit of $0.5 million and $3.1 million related to share-based compensation was recognized in our Condensed Consolidated Statements of Operations as a discrete item in income tax expense for the three and nine months ended September 30, 2018, respectively.

At September 30, 2018, the net deferred tax liability of $149.9 million consisted of net long-term deferred tax assets of $17.6 million and net long-term deferred tax liabilities of $167.5 million. The increase of the net deferred tax liability was primarily related to the acquisition of USI and related tax elections, return to accrual adjustments for tax returns filed in 2018 related to 2017, and other minor legal entity restructuring.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

9. INCOME PER SHARE

Basic net income per share is calculated by dividing net income by the weighted average shares outstanding during the period, without consideration for common stock equivalents.

Diluted net income per share is calculated by adjusting weighted average shares outstanding for the dilutive effect of common stock equivalents outstanding for the period, determined using the treasury stock method.

Basic and diluted net income per share were computed as follows, in thousands, except share and per share amounts:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Net income - basic and diluted	$	42,658	$	31,393	$	96,198	$	53,142

Weighted average number of common shares outstanding - basic		35,091,388		35,022,113		35,084,694		36,203,497

Dilutive effect of common stock equivalents:
RSAs with service-based conditions		135,347		216,724		161,474		215,069
RSAs with market-based conditions		252,278		202,292		245,127		174,559
RSAs with performance-based conditions		23,875		—		7,958		—
Stock options		286,495		296,500		316,104		249,019

Weighted average number of common shares outstanding - diluted		35,789,383		35,737,629		35,815,357		36,842,144

Basic net income per common share	$	1.22	$	0.90	$	2.74	$	1.47

Diluted net income per common share	$	1.19	$	0.88	$	2.69	$	1.44

The following table summarizes shares excluded from the calculation of diluted net income per share because their effect would have been anti-dilutive:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Anti-dilutive common stock equivalents:
RSAs with service-based conditions		9,775		—		3,466		610
RSAs with market-based conditions		—		—		—		—
RSAs with performance-based conditions		—		—		—		—
Stock options		76,030		5,010		62,528		59,298
Total anti-dilutive common stock equivalents		85,805		5,010		65,994		59,908

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

10. SHARE-BASED COMPENSATION

Our eligible employees currently participate in the 2015 LTIP. The 2015 LTIP authorizes the Board to grant stock options, stock appreciation rights, restricted shares, restricted share units, performance awards, and dividend equivalents. All grants are made by issuing new shares and no more than 4.0 million shares of common stock may be issued under the 2015 LTIP. As of September 30, 2018, we had 2.6 million shares available under the 2015 LTIP.

Share-based compensation expense is included in selling, general, and administrative expense. The income tax effect associated with vesting of awards is included in income tax expense. The following table presents the amounts recognized in our Condensed Consolidated Statements of Operations, in thousands:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Share-based compensation expense	$	2,848	$	2,372	$	8,244	$	7,473
Income tax benefit realized from award vestings	$	545	$	1,619	$	3,140	$	2,634

The following table presents a summary of our share-based compensation activity for the nine months ended September 30, 2018, in thousands, except per share amounts:


	RSAs			Options
	Number of Shares	Weighted Average Grant Date Fair Value Per Share		Number of Shares	Weighted Average Grant Date Fair Value Per Share		Weighted Average Exercise Price Per Share		Aggregate Intrinsic Value
Balance December 31, 2017	591.2	$	30.92	683.5	$	11.13	$	28.97	$	31,969.7
Granted	91.7	$	85.43	77.3	$	27.44	$	74.50
Converted/Exercised	(142.4)	$	26.77	(134.5)	$	10.91	$	28.37	$	6,246.7
Forfeited	(40.2)	$	39.76	(14.9)	$	16.98	$	45.46
Balance September 30, 2018	500.3	$	41.30	611.4	$	13.10	$	34.45	$	14,990.9

Exercisable September 30, 2018 (a)				203.8	$	10.65	$	27.55	$	5,965.9

(a)

The weighted average remaining contractual term for vested options is 7.0 years.

We had unrecognized share-based compensation expense relating to unvested awards as shown in the following table, dollars in thousands:


	As of September 30, 2018
	Unrecognized Compensation Expense on Unvested Awards		Weighted Average Remaining Vesting Period
Unrecognized compensation expense related to unvested awards:
RSAs	$	10,777		1.1 years
Options		3,719		1.1 years
Total unrecognized compensation expense related to unvested awards	$	14,496

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Our RSAs with performance-based conditions are evaluated on a quarterly basis with adjustments to compensation expense based on the likelihood of the performance target being achieved or exceeded. The following table shows the range of payouts and the related expense for our outstanding RSAs with performance-based conditions, in thousands:


			Payout Ranges and Related Expense
RSAs with Performance-Based Conditions	Grant Date Fair Value		0%		25%		100%		200%
February 22, 2016	$	1,944	$	—	$	486	$	1,944	$	3,888
February 21, 2017	$	2,012	$	—	$	503	$	2,012	$	4,024
February 19, 2018	$	2,303	$	—	$	576	$	2,303	$	4,606

The fair value of our RSAs with a market-based condition granted under the 2015 LTIP was determined using a Monte Carlo simulation. The following are key inputs in the Monte Carlo analysis for awards granted in 2018 and 2017:


	2018			2017
Measurement period (years)		2.87			2.86
Risk free interest rate		2.36	%		1.46	%
Dividend yield		0.00	%		0.00	%
Estimated fair value of market-based RSAs granted	$	103.31		$	50.06

The fair values of stock options granted under the 2015 LTIP were calculated using the Black-Scholes Options Pricing Model. The following table presents the assumptions used to estimate the fair values of options granted in 2018 and 2017:


	2018			2017
Risk free interest rate		2.78	%		2.18	%
Expected volatility, using historical return volatility and implied volatility		32.50	%		35.00	%
Expected life (in years)		6.0			6.0
Dividend yield		0.00	%		0.00	%
Estimated fair value of options granted	$	27.44		$	14.44

11. SHARE REPURCHASE PROGRAM

On March 1, 2016, our Board authorized the 2016 Repurchase Program, which expired on February 28, 2017. Under the 2016 Repurchase Program we repurchased a total of 788,399 shares of our common stock for an approximate cost of $26.6 million, or $33.72 per share.

On February 24, 2017, our Board authorized the 2017 Repurchase Program, pursuant to which we may purchase up to $200.0 million of our common stock. Share repurchases under the 2017 Repurchase Program may be executed through various means including, without limitation, open market purchases, privately negotiated transactions, accelerated share repurchase transactions, or otherwise. The 2017 Repurchase Program does not obligate the Company to purchase any shares and expires February 24, 2019. The 2017 Repurchase Program may be terminated, increased, or decreased by our Board at its discretion at any time.

The following table sets forth our share repurchases under the 2016 and 2017 Share Repurchase Programs:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Number of shares repurchased		142,780		1,507,443		156,437		2,365,836
Share repurchase cost (in thousands)	$	9,493	$	100,000	$	(a)	$	139,286
Average price per share	$	66.49	$	66.34	$	(a)	$	58.87

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

(a)

On May 5, 2017, under the 2017 Repurchase Program, we entered into the 2017 ASR Agreement. When the agreement became effective on July 5, 2017, we paid BofA $100.0 million in exchange for an initial delivery of 1.5 million shares of our common stock, representing an estimated 80 percent of the total number of shares we expected to receive under the 2017 ASR Agreement. During the nine months ended September 30, 2018, we received an additional 13,657 shares of our common stock from BofA, representing the final settlement of the 2017 ASR Agreement. We purchased a total of 1,521,100 shares of our common stock under the 2017 ASR Agreement at an average price per share of $65.74. Subsequent to the completion of the 2017 ASR Agreement, we purchased an additional 142,780 shares of our common stock at an average price per share of $66.49 under the 2017 Repurchase Program.

12. BUSINESS COMBINATIONS

As part of our strategy to supplement our organic growth and expand our access to additional markets and products, we completed three acquisitions during the nine months ended September 30, 2018, and six acquisitions during the nine months ended September 30, 2017. Each acquisition was accounted for as a business combination under ASC 805, “Business Combinations.” Acquisition related costs for the three and nine months ended September 30, 2018, were $0.6 million and $13.9 million, respectively. Acquisition related costs for the three and nine months ended September 30, 2017, were $0.3 million and $0.7 million, respectively. Acquisition costs are included in selling, general, and administrative expense in our Condensed Consolidated Statements of Operations.

Acquisitions

On January 16, 2017, we acquired substantially all of the assets of Midwest, a heavy commercial fireproofing and insulation company with locations in Chicago, Illinois and Indianapolis, Indiana. The purchase price of approximately $12.2 million was funded by cash on hand.

On February 27, 2017, we acquired substantially all of the assets of EcoFoam. EcoFoam is a residential and light commercial insulation installation company with locations in Colorado Springs and Denver, Colorado. The purchase price of approximately $22.3 million was funded by cash on hand of $20.2 million and contingent consideration of $2.1 million.

On February 27, 2017, we acquired substantially all of the assets of MR Insulfoam, a residential insulation installation company located in Norwalk, Connecticut. The purchase price of approximately $1.5 million was funded by cash on hand.

On March 29, 2017, we acquired substantially all of the assets of Capital, a residential insulation installation company located in Sacramento, California. The purchase price of approximately $7.3 million was funded by cash on hand.

On April 20, 2017, we acquired substantially all of the assets of Superior, a residential insulation installation company located in Seattle, Washington. The purchase price of approximately $10.9 million was funded by cash on hand.

On June 8, 2017, we acquired substantially all of the assets of Canyon, a heavy commercial insulation and firestopping company with locations in Corona, San Diego, and Livermore, California. The purchase price of approximately $34.4 million was funded by cash on hand of $31.9 million and deferred purchase price consideration of $2.5 million.

On January 10, 2018, we acquired ADO, a distributor of insulation accessories, located in Plymouth, Minnesota. The purchase price of approximately $23.0 million was funded by cash on hand of $22.2 million and contingent consideration of $0.8 million.

On January 18, 2018, we acquired substantially all of the assets of Santa Rosa, a residential and commercial insulation company located in Miami, Florida. The purchase price of approximately $5.6 million was funded by cash on hand.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

On May 1, 2018, we acquired USI, a leading distributor and installer of insulation in both residential and commercial construction markets. Our payment of $487.0 million, which included the purchase price of $475.0 million and adjustments for cash and working capital, was funded through net proceeds from the issuance on April 25, 2018, of $400.0 million of Senior Notes together with the net proceeds from the $100.0 million delayed draw term loan commitment under our Amended Credit Agreement. For additional information see Note 4 – Long-Term Debt.

Revenue and net income since the respective acquisition dates included in our Condensed Consolidated Statements of Operations were as follows, in thousands:


	Three Months Ended September 30, 2018				Nine Months Ended September 30, 2018
2018 Acquisitions	Net Sales		Net Income		Net Sales		Net Income
ADO	$	6,631	$	67	$	17,934	$	90
Santa Rosa		1,550		116		4,438		456
USI		100,333		6,457		169,028		8,074
	$	108,514	$	6,640	$	191,400	$	8,620


	Three Months Ended September 30, 2017				Nine Months Ended September 30, 2017
2017 Acquisitions	Net Sales		Net Income		Net Sales		Net Income
Midwest	$	4,503	$	12	$	12,711	$	152
EcoFoam		6,706		669		15,943		894
Superior		3,323		260		6,189		597
Canyon		6,556		925		8,289		1,146
All others		2,808		330		5,749		707
	$	23,896	$	2,196	$	48,881	$	3,496

Pro Forma Results

The following unaudited pro forma information has been prepared as if the 2018 acquisitions described above had taken place on January 1, 2017, and as if the 2017 acquisitions had taken place on January 1, 2016. The unaudited pro forma information is not necessarily indicative of the results that we would have achieved had the transactions actually taken place on January 1, 2017, and January 1, 2016, as applicable. Further, the pro forma information does not purport to be indicative of future financial operating results. Our pro forma results are presented below, in thousands:


	Pro Forma for the Three Months Ended September 30,				Pro Forma for the Nine Months Ended September 30,
	2018			2017	2018			2017
Net sales	$	647,289	$	594,303	$	1,878,179	$	1,743,331
Net income	$	42,658	$	37,799	$	105,410	$	72,214

The following table details the additional expense included in the unaudited pro forma net income as if the 2018 acquisitions described above had taken place on January 1, 2017, and as if the 2017 acquisitions had taken place on January 1, 2016. Our pro forma results are presented below, in thousands:


	Pro Forma for the Three Months Ended September 30,				Pro Forma for the Nine Months Ended September 30,
	2018		2017		2018		2017
Amortization of intangible assets	$	—	$	4,088	$	5,039	$	12,263
Income tax expense (using normalized 27% ETR for 2018 and 38% ETR for 2017)	$	—	$	3,926	$	3,407	$	11,689

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Purchase Price Allocations

The estimated fair values of the assets acquired and liabilities assumed for the 2018 acquisitions, as well as the fair value of consideration transferred, approximated the following as of September 30, 2018, in thousands:


	2018 Acquisitions
	Completed During the Nine Months Ended September 30, 2018
	ADO		Santa Rosa		USI		Total
Estimated fair values:
Cash	$	939	$	—	$	14,817	$	15,756
Accounts receivable		3,434		1,433		62,302		67,169
Inventories		2,337		104		14,135		16,576
Prepaid and other assets		135		7		3,929		4,071
Property and equipment		951		522		34,215		35,688
Intangible assets		14,090		1,850		165,900		181,840
Goodwill		2,631		2,764		280,188		285,583
Accounts payable		(908)		(1,099)		(17,927)		(19,934)
Accrued liabilities		(609)		—		(34,686)		(35,295)
Deferred tax liability		—		—		(35,871)		(35,871)
Net assets acquired	$	23,000	$	5,581	$	487,002	$	515,583


	2018 Acquisitions
	Completed During the Nine Months Ended September 30, 2018
	ADO		Santa Rosa		USI		Total
Fair value of consideration transferred:
Cash	$	22,172	$	5,581	$	487,002	$	514,755
Deferred consideration		—		—		—		—
Contingent consideration		828		—		—		828
Total consideration transferred	$	23,000	$	5,581	$	487,002	$	515,583

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The estimated fair values of the assets acquired and liabilities assumed for the 2017 acquisitions, as well as the fair value of consideration transferred, approximated the following as of September 30, 2018, in thousands:


	2017 Acquisitions
	Completed During the Nine Months Ended September 30, 2017
	Midwest		EcoFoam		Superior		Canyon		All others		Total
Estimated fair values:
Accounts receivable	$	6,576	$	3,819	$	2,012	$	8,222	$	678	$	21,307
Inventories		75		1,119		321		575		141		2,231
Prepaid and other assets		—		27		1		29		6		63
Property and equipment		655		1,544		361		460		357		3,377
Intangible assets		2,740		6,700		5,280		15,220		3,640		33,580
Goodwill		3,538		10,796		3,662		10,072		4,037		32,105
Accounts payable		(1,359)		(1,378)		(681)		(163)		(26)		(3,607)
Accrued liabilities		—		(302)		(4)		—		—		(306)
Net assets acquired	$	12,225	$	22,325	$	10,952	$	34,415	$	8,833	$	88,750


	2017 Acquisitions
	Completed During the Nine Months Ended September 30, 2017
	Midwest		EcoFoam		Superior		Canyon		All others		Total
Fair value of consideration transferred:
Cash (a)	$	12,225	$	20,822	$	10,952	$	33,532	$	8,833	$	86,364
Deferred consideration		—		—		—		883		—		883
Contingent consideration		—		1,503		—		—		—		1,503
Total consideration transferred	$	12,225	$	22,325	$	10,952	$	34,415	$	8,833	$	88,750

(a) For Canyon, includes $1,667 of deferred consideration paid during the nine months ended September 30, 2018.

Estimates of acquired intangible assets related to the acquisitions are as follows, as of September 30, 2018, dollars in thousands:


	Estimated Fair Value		Weighted Average Estimated Useful Life (Years)
2018 Acquisitions:
Customer relationships	$	169,320		12
Trademarks and trade names		11,260		9
Non-competition agreements		1,260		5
Total intangible assets for 2018 acquisitions	$	181,840		11

2017 Acquisitions:
Customer relationships	$	26,170		10
Trademarks and trade names		1,780		10
Non-competition agreements		5,630		5
Total intangible assets for 2017 acquisitions	$	33,580		9

As third party or internal valuations are finalized, certain tax aspects of the foregoing transaction are completed, and customer post-closing reviews are concluded, adjustments may be made to the fair value of assets acquired, and in some cases total purchase price, through the end of each measurement period, generally one year following the applicable acquisition date. Various insignificant adjustments to the fair value of assets acquired, and in some cases total purchase price, have been made to certain business combinations since the respective dates of acquisition.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Goodwill to be recognized in connection with these acquisitions is attributable to the synergies expected to be realized and improvements in the businesses after the acquisitions. Of the $285.6 million of goodwill recorded from the 2018 acquisitions, $33.5 million is expected to be deductible for income tax purposes.

Contingent Consideration

The acquisition of EcoFoam includes a contingent consideration arrangement that requires additional consideration to be paid by TopBuild to the sellers of EcoFoam based on EcoFoam’s attainment of annual revenue targets over a three-year period. In the second quarter of 2018 we made the first contingent payment of $0.8 million. The total amount of undiscounted contingent consideration which TopBuild may be required to pay under the arrangement is $2.5 million. The fair value of $2.1 million contingent consideration recognized on the acquisition date was estimated by applying the income approach using discounted cash flows. That measure is based on significant Level 3 inputs not observable in the market. The significant assumption includes a discount rate of 9.5 percent. Changes in the fair value measurement each period reflect the passage of time as well as the impact of adjustments, if any, to the likelihood of achieving the specified targets.

The acquisition of ADO includes a contingent consideration arrangement that requires additional consideration to be paid by TopBuild to the sellers of ADO based on the achievement of certain EBITDA thresholds over a two-year period. The range of the undiscounted amounts TopBuild may be required to pay under the contingent consideration agreement is between zero and $1.0 million. The fair value of the contingent consideration recognized on the acquisition date of $0.8 million was estimated by applying the income approach using discounted cash flows. That measure is based on significant Level 3 inputs not observable in the market. The significant assumption includes a discount rate of 9.5 percent. Changes in the fair value measurement each period reflect the passage of time as well as the impact of adjustments, if any, to the likelihood of achieving the specified targets.

Contingent consideration is recorded in the Condensed Consolidated Balance Sheets in accrued liabilities and other liabilities. Adjustments to the fair value of contingent consideration are reflected in selling, general, and administrative expense in the Condensed Consolidated Statements of Operations and are included in the acquisition related costs above.

The following table presents the fair value of contingent consideration, in thousands:


	EcoFoam		ADO
Date of Acquisition	February 27, 2017		January 10, 2018
Fair value of contingent consideration recognized at acquisition date	$	2,110	$	828

Contingent consideration at December 31, 2017	$	2,259	$	—
Additions		—		828
Change in fair value of contingent consideration during the nine months ended September 30, 2018		120		(493)
Payment of contingent consideration during the nine months ended September 30, 2018		(841)		—
Liability balance for contingent consideration at September 30, 2018	$	1,538	$	335

13. CLOSURE COSTS

We generally recognize expenses related to closures and position eliminations at the time of announcement or notification. Such costs include termination and other severance benefits, lease abandonment costs, and other transition costs. Closure costs are reflected in our Condensed Consolidated Statements of Operations as selling, general, and administrative expense. Accrued closure costs are reflected in our Condensed Consolidated Balance Sheets as accrued liabilities.

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TOPBUILD CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

In connection with the acquisition of USI, management performed an evaluation of the resources necessary to effectively operate the acquired business. During the second quarter of 2018, management committed to a plan to close the existing USI corporate office in St. Paul, Minnesota, and consolidate certain administrative functions to our Daytona Beach, Florida, Branch Support Center. As a result, the Company expects to incur approximately $6.6 million of closure costs in connection with this activity. Closure costs pertaining to the USI acquisition are primarily included in general corporate expenses for segment reporting purposes.

The following table details our total estimated closure costs by cost type, of which $2.2 million were incurred during the three months ended September 30, 2018, pertaining to the above closure and transition related to the USI acquisition, in thousands:


			Closure Costs				Non-Cash
			Incurred for the		Cash Payments for		Adjustments for
	Closure Costs		Nine Months		the Nine Months		the Nine Months		Closure Costs
Segment /	Liability at		Ended		Ended		Ended		Liability at
Cost Type	December 31, 2017		September 30, 2018		September 30, 2018		September 30, 2018		September 30, 2018
Corporate:
Severance	$	—	$	5,681	$	(2,247)	$	(223)	$	3,211
Lease abandonment		—		400		(66)		—		334
Other costs		—		9		(9)		—		—
Total Corporate:	$	—	$	6,090	$	(2,322)	$	(223)	$	3,545

We expect to pay the remaining closure costs primarily within one year. Non-cash adjustments in the table above relate to true-up of estimates to actual amounts and other subsequent changes.

14. ACCRUED LIABILITIES

The following table sets forth the components of accrued liabilities, in thousands:


	As of
	September 30,		December 31,
	2018		2017
Accrued liabilities:
Salaries, wages, and commissions	$	34,448	$	25,470
Insurance liabilities		27,574		19,770
Other		54,221		29,847
Total accrued liabilities	$	116,243	$	75,087

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

TopBuild, headquartered in Daytona Beach, Florida, is the leading installer and distributor of insulation and building material products to the U.S. construction industry. We trade on the NYSE under the ticker symbol “BLD.”

We operate in two segments: Installation (TruTeam) and Distribution (Service Partners). Our Installation segment installs insulation and other building products nationwide through our TruTeam contractor services business, which, as of September 30, 2018, had over 200 branches located in 41 states. We install various insulation applications, including fiberglass batts and rolls, blown-in loose fill fiberglass, blown-in loose fill cellulose, and polyurethane spray foam. Additionally, we install other building products including rain gutters, glass and windows, after-paint products, garage doors, fireplaces, shower enclosures, and closet shelving. We handle every stage of the installation process, including procurement of material from leading manufacturers, project scheduling and logistics, multi-phase professional installation, and installation quality assurance.

Our Distribution segment sells and distributes insulation and other building products, including rain gutters, fireplaces, closet shelving, and roofing materials through our Service Partners business, which, as of September 30, 2018, had over 75 branches located in 32 states. Our Service Partners customer base consists of thousands of insulation contractors of all sizes, gutter contractors, weatherization contractors, other contractors, dealers, metal building erectors, and modular home builders.

We believe that having both TruTeam and Service Partners provides us with a number of distinct competitive advantages. First, the combined buying power of our two business segments, along with our national scale, strengthens our ties to the major manufacturers of insulation and other building products. This helps to ensure we are buying competitively and ensures the availability of supply to our local branches and distribution centers. The overall effect is driving efficiencies through our supply chain. Second, being a leader in both installation and distribution allows us to more effectively reach a broader set of builder customers, regardless of their size or geographic location in the U.S., and leverage housing growth wherever it occurs. Third, during industry downturns, many insulation contractors who buy directly from manufacturers during industry peaks return to purchasing through distributors. As a result, this helps to reduce our exposure to cyclical swings in our business.

For additional details pertaining to our operating results by segment, see Note 6 – Segment Information to our unaudited condensed consolidated financial statements contained in Part I, Item 1 of this Quarterly Report, which is incorporated herein by reference.

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THIRD QUARTER 2018 VERSUS THIRD QUARTER 2017

The following discussion and analysis contains forward-looking statements and should be read in conjunction with the unaudited condensed consolidated financial statements, the notes thereto, and the section entitled “Forward-Looking Statements” included in this Quarterly Report.

The following table sets forth our net sales, gross profit, operating profit, and margins, as reported in our Condensed Consolidated Statements of Operations, in thousands:


	Three Months Ended September 30,
	2018			2017
Net sales	$	647,289		$	489,044
Cost of sales		485,424			368,205
Cost of sales ratio		75.0	%		75.3	%

Gross profit		161,865			120,839
Gross profit margin		25.0	%		24.7	%

Selling, general, and administrative expense		95,648			71,277
Selling, general, and administrative expense to sales ratio		14.8	%		14.6	%

Operating profit		66,217			49,562
Operating profit margin		10.2	%		10.1	%

Other expense, net		(9,203)			(2,452)
Income tax expense		(14,356)			(15,717)
Net income	$	42,658		$	31,393
Net margin		6.6	%		6.4	%

Sales and Operations

Net sales increased 32.4 percent for the three months ended September 30, 2018, from the comparable period of 2017. The increase was principally driven by our three acquisitions completed in 2018, increased selling prices, and increased organic sales volume. Our sales volume benefited from overall growth in the housing market, as well as our continued focus on organically growing our residential and commercial business.

Our gross profit margins were 25.0 percent and 24.7 percent for the three months ended September 30, 2018 and 2017, respectively. Gross profit margin improved as increased selling prices and USI acquisition synergies more than offset the negative impact of higher material costs.

Selling, general, and administrative expense, as a percentage of sales, was 14.8 percent and 14.6 percent for the three months ended September 30, 2018 and 2017, respectively. Increased selling, general, and administrative expense as a percentage of sales was primarily a result of higher amortization, acquisition and closure costs related to the USI acquisition, partially offset by USI acquisition synergies and lower fixed costs as a percentage of sales due to higher sales volume.

Operating margins were 10.2 percent and 10.1 percent for the three months ended September 30, 2018 and 2017, respectively. The increase in operating margins was due to increased selling prices, USI acquisition synergies, and lower fixed costs as a percentage of sales due to higher sales volume, partially offset by higher material costs and higher amortization, acquisition and closure costs related to the USI acquisition.

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Closure and Related Costs

We incurred costs of $2.2 million for the three months ended September 30, 2018, related to the acquisition of USI, including the closing of USI’s St. Paul, Minnesota corporate office and consolidation of certain administrative functions to our Daytona Beach, Florida, Branch Support Center. See Note 13 – Closure Costs to our unaudited condensed consolidated financial statements contained in Part I, Item 1 of this Quarterly Report. We incurred an expense of $0.3 million for the three months ended September 30, 2017, related to the consolidation of certain back-office operations to our Daytona Beach, Florida, Branch Support Center.

Business Segment Results

The following table sets forth our net sales and operating profit margins by business segment, in thousands:


	Three Months Ended September 30,
	2018			2017			Percent Change
Sales by business segment:
Installation	$	464,540		$	333,238		39.4	%
Distribution		212,948			181,146		17.6	%
Intercompany eliminations and other adjustments		(30,199)			(25,340)
Net sales	$	647,289		$	489,044		32.4	%

Operating profit by business segment:
Installation	$	61,004		$	40,862		49.3	%
Distribution		19,229			18,300		5.1	%
Intercompany eliminations and other adjustments		(5,658)			(4,413)
Operating profit before general corporate expense		74,575			54,749		36.2	%
General corporate expense, net		(8,358)			(5,187)
Operating profit	$	66,217		$	49,562		33.6	%

Operating profit margins:
Installation		13.1	%		12.3	%
Distribution		9.0	%		10.1	%
Operating profit margin before general corporate expense		11.5	%		11.2	%
Operating profit margin		10.2	%		10.1	%

Installation

Sales

Sales in the Installation segment increased $131.3 million, or 39.4 percent, for the three months ended September 30, 2018, as compared to the same period in 2017. Sales increased 28.0 percent from acquired branches and 4.9 percent due to increased selling prices. Sales volume increased due to overall growth in the housing market, as well as our continued focus on organically growing our residential and commercial business.

Operating margins

Operating margins in the Installation segment were 13.1 percent and 12.3 percent for the three months ended September 30, 2018 and 2017, respectively. The increase in operating margins was due to increased selling prices, USI acquisition synergies, and lower fixed costs as a percentage of sales due to higher sales volume, partially offset by higher material costs and higher amortization expense.

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Distribution

Sales

Sales in the Distribution segment increased $31.8 million, or 17.6 percent, for the three months ended September 30, 2018, as compared to the same period in 2017. Sales increased 8.8 percent from acquired branches and 7.6 percent due to increased selling prices. Sales volume increased due to overall growth in the housing market, as well as our continued focus on organic growth.

Operating margins

Operating margins in the Distribution segment were 9.0 percent and 10.1 percent for the three months ended September 30, 2018 and 2017, respectively. Operating margins were negatively impacted by higher material costs and higher amortization expense, partially offset by higher selling prices and lower fixed costs as a percentage of sales due to higher sales volume.

OTHER ITEMS

Other expense, net

Other expense, net, which primarily consisted of interest expense, was $9.2 million and $2.5 million for the three months ended September 30, 2018 and 2017, respectively. The increase in other expense, net for the three months ended September 30, 2018, primarily related to the issuance of our $400.0 million Senior Notes and our borrowing of the $100.0 million delayed draw term loan to fund our acquisition of USI, as well as the issuance of $20.1 million of equipment notes in 2018.

Income tax expense

Income tax expense was $14.4 million, an ETR of 25.2 percent, for the three months ended September 30, 2018, compared to $15.7 million, an ETR of 33.4 percent, for the comparable period in 2017. The lower 2018 rate was due to the lower Federal tax rate enacted by the Tax Cuts and Jobs Act and the impact of discrete benefits related to share-based compensation, partially offset by return to accrual adjustments for tax returns filed in 2018 related to 2017.

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FIRST NINE MONTHS 2018 VERSUS FIRST NINE MONTHS 2017

The following table sets forth our net sales, gross profit, operating profit, and margins, as reported in our Condensed
Consolidated Statements of Operations, in thousands:


	Nine Months Ended September 30,
	2018			2017
Net sales	$	1,744,702		$	1,404,865
Cost of sales		1,326,777			1,065,789
Cost of sales ratio		76.0	%		75.9	%

Gross profit		417,925			339,076
Gross profit margin		24.0	%		24.1	%

Selling, general, and administrative expense (exclusive of significant legal settlement, shown separately below)		274,134			222,181
Selling, general, and administrative expense (exclusive of significant legal settlement, shown separately below) to sales ratio		15.7	%		15.8	%

Significant legal settlement		—			30,000
Significant legal settlement to sales ratio		—	%		2.1	%

Operating profit		143,791			86,895
Operating profit margin		8.2	%		6.2	%

Other expense, net		(18,734)			(6,614)
Income tax expense		(28,859)			(27,139)
Net income	$	96,198		$	53,142
Net margin		5.5	%		3.8	%

Sales and Operations

Net sales increased 24.2 percent for the nine months ended September 30, 2018, from the comparable period of 2017. The increase was principally driven by our three acquisitions completed in 2018, six acquisitions completed during 2017, increased selling prices, and increased organic sales volume. Our sales volume benefited from overall growth in the housing market, as well as our continued focus on organically growing our residential and commercial business.

Our gross profit margins were 24.0 percent and 24.1 percent for the nine months ended September 30, 2018 and 2017, respectively. Gross profit margin was negatively impacted by higher material costs, partially offset by USI acquisition synergies and increased selling prices.

Selling, general, and administrative expense, exclusive of the significant legal settlement discussed below, as a percentage of sales, was 15.7 percent and 15.8 percent for the nine months ended September 30, 2018 and 2017, respectively. Decreased selling, general, and administrative expense as a percentage of sales was a result of lower fixed costs as a percentage of sales due to higher sales volume, USI acquisition synergies and lower legal expenses, partially offset by higher amortization, acquisition and closure costs related to the USI acquisition. We incurred a $30 million legal settlement during the nine months ended September 30, 2017, related to the settlement of a breach of contract action related to our termination of an insulation supply agreement with Owens Corning.

Operating margins were 8.2 percent and 6.2 percent for the nine months ended September 30, 2018 and 2017, respectively, inclusive of the significant Owens Corning legal settlement. The increase in operating margins for the 2018 period primarily resulted from the $30 million legal settlement with Owens Corning incurred in the prior year, higher selling prices, USI acquisition synergies, lower legal expenses and lower fixed costs as a percentage of sales due to higher sales volume, partially offset by higher material costs and higher amortization, acquisition and closure costs related to the USI acquisition.

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Closure and Related Costs

We incurred closure costs of $5.9 million for the nine months ended September 30, 2018, related to the acquisition of USI including the closing of USI’s St. Paul, Minnesota corporate office and consolidation of certain administrative functions to our Daytona Beach, Florida, Branch Support Center. See Note 13 – Closure Costs to our unaudited condensed consolidated financial statements contained in Part I, Item 1 of this Quarterly Report. We incurred expenses of $2.0 million during the nine months ended September 30, 2017 related to the consolidation of certain back-office operations to our Daytona Beach, Florida, Branch Support Center.

Business Segment Results

The following table sets forth our net sales and operating profit margins by business segment, in thousands:


	Nine Months Ended September 30,
	2018			2017			Percent Change
Sales by business segment:
Installation	$	1,223,357		$	945,109		29.4	%
Distribution		606,335			526,452		15.2	%
Intercompany eliminations and other adjustments		(84,990)			(66,696)
Net sales	$	1,744,702		$	1,404,865		24.2	%

Operating profit by business segment:
Installation (exclusive of significant legal settlement, shown separately below)	$	139,969		$	96,985		44.3	%
Significant legal settlement (Installation segment)		—			(30,000)
Distribution		57,141			50,806		12.5	%
Intercompany eliminations and other adjustments		(15,382)			(11,393)
Operating profit before general corporate expense		181,728			106,398		70.8	%
General corporate expense, net		(37,937)			(19,503)
Operating profit	$	143,791		$	86,895		65.5	%

Operating profit margins:
Installation (exclusive of significant legal settlement)		11.4	%		10.3	%
Installation (inclusive of significant legal settlement)		11.4	%		7.1	%
Distribution		9.4	%		9.7	%
Operating profit margin before general corporate expense		10.4	%		7.6	%
Operating profit margin		8.2	%		6.2	%

Installation

Sales

Sales in the Installation segment increased $278.2 million, or 29.4 percent, for the nine months ended September 30, 2018, compared to the same period in 2017. Sales increased 19.0 percent from acquired branches and 3.6 percent due to increased selling prices. Sales volume increased due to overall growth in the housing market, as well as our continued focus on organically growing our residential and commercial business.

Operating margins

Operating margins in the Installation segment were 11.4 percent and 7.1 percent for the nine months ended September 30, 2018 and 2017, respectively. The increase in operating margins related to the $30 million legal settlement with Owens Corning incurred in the prior year, as well as higher selling prices, USI acquisition synergies, lower legal expenses and lower fixed costs as a percentage of sales due to higher sales volume, partially offset by higher material costs and higher amortization, acquisition and closure costs related to the USI acquisition.

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Distribution

Sales

Sales in the Distribution segment increased $79.9 million, or 15.2 percent, for the nine months ended September 30, 2018, compared to the same period in 2017. Sales increased 7.0 percent due to increased selling prices and 6.3 percent from acquired branches. Sales volume increased due to overall growth in the housing market, as well as our continued focus on organic growth.

Operating margins

Operating margins in the Distribution segment were 9.4 percent and 9.7 percent for the nine months ended September 30, 2018 and 2017, respectively. Operating margins were negatively impacted by higher material costs and higher amortization expense, partially offset by higher selling prices and lower fixed costs as a percentage of sales due to higher sales volume.

OTHER ITEMS

Other expense, net

Other expense, net, which primarily consisted of interest expense, was $18.7 million and $6.6 million for the nine months ended September 30, 2018 and 2017, respectively. The increase in other expense, net for the nine months ended September 30, 2018, primarily related to the issuance of our $400.0 million Senior Notes and our borrowing of the $100.0 million delayed draw term loan to fund our acquisition of USI, as well as the issuance of $20.1 million of equipment notes in 2018.

Income tax expense

Income tax expense was $28.9 million, an ETR of 23.1 percent, for the nine months ended September 30, 2018, compared to $27.1 million, an ETR of 33.8 percent, for the comparable period in 2017. The lower 2018 rate was due to the lower Federal tax rate enacted by the Tax Cuts and Jobs Act and the impact of discrete benefits related to share-based compensation, partially offset by State tax adjustments from rate changes related to the USI acquisition and from return to accrual adjustments for tax returns filed in 2018 related to 2017.

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Cash Flows and Liquidity

Significant sources (uses) of cash and cash equivalents for the nine months ended September 30, 2018 and 2017, are summarized as follows, in thousands:


	Nine Months Ended September 30,
	2018			2017
Changes in cash and cash equivalents:
Net cash provided by operating activities	$	96,033		$	54,618
Purchases of property and equipment		(42,379)			(13,088)
Acquisition of businesses, net of cash acquired of $15,756 in 2018		(500,666)			(84,040)
Proceeds from sale of property and equipment		502			453
Other investing, net		31			178
Proceeds from issuance of Senior Notes		400,000			—
Proceeds from issuance of term loan		100,000			250,000
Repayment of term loan		(11,875)			(183,125)
Proceeds from equipment notes		20,104			—
Repayment of equipment notes		(1,222)			—
Proceeds from revolving credit facility		90,000			170,000
Repayment of revolving credit facility		(90,000)			(165,000)
Payment of debt issuance costs		(7,819)			(2,150)
Taxes withheld and paid on employees' equity awards		(5,433)			(4,475)
Repurchase of shares of common stock		(9,493)			(139,286)
Payment of contingent consideration		(841)			—
Cash and cash equivalents increase (decrease)	$	36,942		$	(115,915)

Receivables, net	$	419,706		$	315,382
Inventories, net		161,875			116,781
Accounts payable		(300,938)			(242,616)
Receivables, net plus inventories, net less accounts payable	$	280,643		$	189,547

Increase in receivables, net plus inventories, net less accounts payable from prior year	$	91,096		$	35,994
Receivables, net plus inventories, net less accounts payable as a percentage of TTM net sales (a)		11.3	%		10.0	%

(a)

Net sales for the TTM have been adjusted for the pro forma effect of acquired branches.

Net cash flows provided by operating activities increased $41.4 million for the nine months ended September 30, 2018, as compared to the prior year period. The increase was primarily due to a $43.1 million increase in net income.

The increase in receivables, net plus inventories, net less accounts payable as a percentage of TTM net sales as of September 30, 2018, was primarily due to the acquisition of USI and some strategic inventory purchases.

Net cash used in investing activities was $542.5 million for the nine months ended September 30, 2018, primarily comprised of $500.7 million of net cash for the acquisition of USI and ADO and substantially all of the assets of Santa Rosa, and $42.4 million for purchases of property and equipment partially related to our decision to begin purchasing rather than leasing vehicles, partially offset by $0.5 million of proceeds from the sale of property and equipment. Net cash used in investing activities was $96.5 million for the nine months ended September 30, 2017, primarily comprised of $84.0 million for the acquisitions of substantially all of the assets of Midwest, EcoFoam, MR Insulfoam, Capital, Superior, and Canyon and $13.1 million for purchases of property and equipment, partially offset by $0.5 million of proceeds from the sale of property and equipment.

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Net cash provided by financing activities was $483.4 million for the nine months ended September 30, 2018. We received $400.0 million for the issuance of our Senior Notes and $100.0 million from the delayed draw on our term loan related to our acquisition of USI. We received $20.1 million of proceeds from equipment financing notes related to our decision to begin purchasing rather than leasing vehicles. We used $11.9 million for payments on our term loan, $7.8 million for payment of debt issuance costs related to our Amended Credit Agreement and our Senior Notes, $5.4 million for purchases of common stock for tax withholding obligations related to the vesting and exercise of share-based incentive awards during the nine months ended September 30, 2018, and $1.2 million for payments on our equipment financing notes. We also made a payment of $0.8 million of contingent consideration for EcoFoam. We drew $90.0 million on our revolving credit facility and repaid $90.0 million during the nine months ended September 30, 2018.

Net cash used in financing activities was $74.0 million for the nine months ended September 30, 2017. We received $250.0 million of proceeds from the issuance of long-term debt related to our Amended Credit Agreement. We used $175.0 million of the proceeds to pay off all amounts outstanding under our Old Credit Agreement, we used $139.3 million of cash for common stock repurchases related to our share repurchase programs including our 2017 ASR Agreement, $5.0 million of repayments of our previous long-term debt, $3.1 million of payments for our Amended Credit Agreement, $2.2 million for payment of debt issuance costs, and $4.5 million for purchases of common stock for tax withholding obligations related to the vesting of share-based incentive awards during the nine months ended September 30, 2017. We drew $170.0 million on our revolving credit facility and repaid $165.0 million during the nine months ended September 30, 2017.

We have access to liquidity through our cash from operations and available borrowing capacity under our Amended Credit Agreement, which provides for borrowing and/or standby letter of credit issuances of up to $250.0 million under the Revolving Facility. We believe that our cash flows from operations, combined with our current cash levels and available borrowing capacity, will be adequate to support our ongoing operations and to fund our debt service requirements, capital expenditures, and working capital for at least the next twelve months. Cash flows are seasonally stronger in the third and fourth quarters as a result of historically increased new construction activity during those periods.

The following table summarizes our liquidity, in thousands:


	As of
	September 30,		December 31,
	2018		2017
Cash and cash equivalents	$	93,463	$	56,521

Revolving Facility		250,000		250,000
Less: standby letters of credit		(59,288)		(47,055)
Capacity under Revolving Facility		190,712		202,945

Additional term loan capacity under delayed draw feature		―		100,000
Total liquidity	$	284,175	$	359,466

We occasionally use performance bonds to ensure completion of our work on certain larger customer contracts that can span multiple accounting periods. Performance bonds generally do not have stated expiration dates; rather, we are released from the bonds as the related contractual performance is completed. We also have bonds outstanding for licensing and insurance.

The following table summarizes our outstanding bonds, in thousands:


	As of
	September 30,		December 31,
	2018		2017
Outstanding bonds:
Performance bonds	$	62,343	$	44,765
Licensing, insurance, and other bonds		20,795		17,013
Total bonds	$	83,138	$	61,778

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OUTLOOK

New home construction activity is recovering at a slower pace, but it remains below historical averages. Household formations and the available housing supply point towards continued long-term growth in new home construction, however a number of factors, including credit availability, housing affordability, interest rates, student debt, and labor availability could cause volatility in the market.

CONTRACTUAL OBLIGATIONS

There have been no material changes to our contractual obligations from those previously disclosed in our Annual Report for the year ended December 31, 2017, as filed with the SEC on February 27, 2018, except for the issuance of our $400.0 million Senior Notes and the accessing of $100.0 million delayed draw on our term loan during the second quarter of 2018 in connection with the acquisition of USI, as well as our issuance of equipment notes in 2018. See further information as disclosed in Note 4 – Long-Term Debt to our unaudited condensed consolidated financial statements contained in Part I, Item 1 of this Quarterly Report.

CRITICAL ACCOUNTING POLICIES

We prepare our condensed consolidated financial statements in conformity with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities, at the date of the financial statements, and the reported amounts of sales and expenses during the reporting period. Actual results could differ from those estimates. Our critical accounting policies have not changed materially from those previously reported in our Annual Report for year ended December 31, 2017, as filed with the SEC on February 27, 2018.

APPLICATION OF NEW ACCOUNTING STANDARDS

Information regarding application of new accounting standards is incorporated by reference from Note 2 – Accounting Policies to our unaudited condensed consolidated financial statements contained in Part I, Item 1 of this Quarterly Report.

FORWARD-LOOKING STATEMENTS

Statements contained in this report that reflect our views about future periods, including our future plans and performance, constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as “will,” “would,” “anticipate,” “expect,” “believe,” “designed,” “plan,” or “intend,” the negative of these terms, and similar references to future periods. These views involve risks and uncertainties that are difficult to predict and, accordingly, our actual results may differ materially from the results discussed in our forward-looking statements. We caution you against unduly relying on any of these forward-looking statements. Our future performance may be affected by our reliance on residential new construction, residential repair/remodel, and commercial construction; our reliance on third-party suppliers and manufacturers; our ability to attract, develop, and retain talented personnel and our sales and labor force; our ability to maintain consistent practices across our locations; and our ability to maintain our competitive position. We discuss the material risks we face under the caption entitled “Risk Factors” in our Annual Report for the year ended December 31, 2017, as filed with the SEC on February 27, 2018, as well as under the caption entitled “Risk Factors” in this Quarterly Report. Our forward-looking statements in this filing speak only as of the date of this filing. Factors or events that could cause our actual results to differ may emerge from time to time and it is not possible for us to predict all of them. Unless required by law, we undertake no obligation to update publicly any forward-looking statements as a result of new information, future events, or otherwise.

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Our credit agreement became effective on May 5, 2017, and was amended on March 28, 2018, to facilitate the acquisition of USI. The Amended Credit Agreement consists of a senior secured term loan facility in the amount of $250.0 million, $100.0 million of additional term loan capacity under a delayed draw feature, which was accessed on May 1, 2018, and a revolving facility in the amount of $250.0 million. In addition, on April 25, 2018, we issued $400.0 million of Senior Notes. The Senior Notes bear a fixed rate of interest and therefore are excluded from the calculation below as they are not subject to fluctuations in interest rates.

Interest payable on both the term loan facility and revolving facility under the Amended Credit Agreement is based on a variable interest rate. As a result, we are exposed to market risks related to fluctuations in interest rates on this outstanding indebtedness. As of September 30, 2018, we had $331.9 million outstanding under our term loan facility, and the applicable interest rate as of such date was 3.33 percent. Based on our outstanding borrowings under the Amended Credit Agreement as of September 30, 2018, a 100 basis point increase in the interest rate would result in a $3.2 million increase in our annualized interest expense. There was no outstanding balance under the revolving facility as of September 30, 2018.

Item 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of September 30, 2018.

We acquired USI on May 1, 2018. As permitted by the SEC Staff interpretive guidance for newly acquired businesses, management excluded USI from its evaluation of internal control over financial reporting for the period covered by this Quarterly Report. We do not anticipate that the integration of USI will result in any material changes to our internal control over financial reporting, and we plan to incorporate USI into our evaluation within one year from the date of acquisition. As the post-closing integration progresses, we will continue to review, and as appropriate to integrate, USI’s internal controls and processes. See Note 12 – Business Combinations to our unaudited condensed consolidated financial statements contained in Part I, Item 1 of this Quarterly Report, for the significance of USI to our condensed consolidated financial statements.

Changes in Internal Control over Financial Reporting

There was no change in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) in the most recent fiscal quarter ended September 30, 2018, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

The information set forth under the caption “Litigation” in Note 7 – Other Commitments and Contingencies to our unaudited condensed consolidated financial statements contained in Part I, Item 1 of this Quarterly Report, is incorporated by reference herein.

Item 1A. RISK FACTORS

Except as set forth below, there have been no material changes to our risk factors as previously disclosed in our 2017 Annual Report as filed with the SEC on February 27, 2018.

Risks Related to the USI Acquisition and Any Other Acquired Businesses in the Future

We may not be able to successfully integrate USI and other businesses that we may acquire in the future.

Our ability to successfully implement our business plan and achieve targeted financial results is dependent on our ability to successfully integrate USI and other businesses that we may acquire in the future. The process of integrating USI, and any other acquired businesses, involves risks. These risks include, but are not limited to:

demands on management related to the increase in the size of our business;

diversion of management’s attention from the management of daily operations;

difficulties in the assimilation of different corporate cultures and business practices;

difficulties in conforming the acquired company’s accounting policies to ours;

retaining employees who may be vital to the integration of departments, information technology systems, including accounting systems, technologies, books and records, and procedures, and maintaining uniform standards, such as internal accounting controls, procedures, and policies; and

costs and expenses associated with any undisclosed or potential liabilities.

Failure to successfully integrate USI, and any other acquired businesses, may result in reduced levels of revenue, earnings, or operating efficiency than might have been achieved if we had not acquired such businesses.

In addition, our acquisition of USI resulted, and any future acquisitions could result, in the incurrence of additional debt and related interest expense, contingent liabilities, and amortization expenses related to intangible assets, which could have a material adverse effect on our financial condition, operating results, and cash flow.

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We may not be able to achieve the benefits that we expect to realize as a result of the acquisition of USI or any future acquisitions. Failure to achieve such benefits could have an adverse effect on our financial condition and results of operations.

We may not be able to realize anticipated cost savings, revenue enhancements, or other synergies from the USI acquisition or any future acquisitions, either in the amount or within the time frame that we expect. In addition, the costs of achieving these benefits may be higher than, and the timing may differ from, what we expect. Our ability to realize anticipated cost savings, synergies, and revenue enhancements may be affected by a number of factors, including, but not limited to, the following:

the use of more cash or other financial resources on integration and implementation activities than we expect;

unanticipated increases in expenses unrelated to the USI acquisition or any future acquisition, which may offset the expected cost savings and other synergies from the USI acquisition or any future acquisition;

our ability to eliminate duplicative back office overhead and redundant selling, general, and administrative functions; and

our ability to avoid labor disruptions in connection with the integration of USI or any future acquisition, particularly in connection with any headcount reduction.

Specifically, while we expect the USI acquisition or any future acquisition to create opportunities to reduce our combined operating costs, these cost savings reflect estimates and assumptions made by our management, and it is possible that our actual results will not reflect these estimates and assumptions within our anticipated timeframe or at all.

If we fail to realize anticipated cost savings, synergies, or revenue enhancements, our financial results may be adversely affected, and we may not generate the cash flow from operations that we anticipate.

USI or any other acquired businesses may have liabilities that are not known to us.

USI or any other acquired businesses may have liabilities that we failed, or were unable, to discover in the course of performing our due diligence investigations of USI or any other acquired businesses. We cannot assure you that the indemnification available to us under the acquisition agreement in respect of the USI acquisition or any other acquired businesses or the representation and warranty insurance procured by us in connection with such agreement will be sufficient in amount, scope, or duration to fully offset the possible liabilities associated with USI’s business or any other acquired businesses or property that we will assume upon consummation of the USI acquisition or any other acquired businesses. We may learn additional information about USI or any other acquired businesses that materially adversely affects us, such as unknown or contingent liabilities and liabilities related to compliance with applicable laws. Any such liabilities, individually or in the aggregate, could have a material adverse effect on our business, financial condition, and results of operation.

Adverse credit ratings could increase our costs of borrowing money and limit our access to capital markets and commercial credit.

Moody’s Investor Service and Standard & Poor’s routinely evaluate our credit ratings related to our Senior Notes. If these rating agencies downgrade any of our current credit ratings, our borrowing costs could increase and our access to the capital and commercial credit markets could be adversely affected.

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Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The following table provides information regarding the repurchase of our common stock for the three months ended September 30, 2018, in thousands, except share and per share data:


Period	Total Number of Shares Purchased	Average Price Paid per Common Share		Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
July 1, 2018 - July 31, 2018	—	$	—	—	$	65,000
August 1, 2018 - August 31, 2018	63,200	$	71.61	63,200	$	60,474
September 1, 2018 - September 30, 2018	79,580	$	62.42	79,580	$	55,507
Total	142,780	$	66.49	142,780

For more information see Note 11 – Share Repurchase Program to our unaudited condensed consolidated financial statements contained in Part I, Item 1 of this Quarterly Report. All repurchases were made using cash resources. Excluded from this disclosure are shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards and exercise of options.

Item 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

Item 4. MINE SAFETY DISCLOSURES

Not applicable.

Item 5. OTHER INFORMATION

Not applicable.

Item 6. EXHIBITS

The Exhibits listed on the accompanying Index to Exhibits are filed or furnished (as noted on such Index) as part of this Quarterly Report and incorporated herein by reference.

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INDEX TO EXHIBITS


		Incorporated by Reference			Filed
Exhibit No.	Exhibit Title	Form	Exhibit	Filing Date	Herewith
31.1	Principal Executive Officer Certification required by Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002				X

31.2	Principal Financial Officer Certification required by Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002				X

32.1‡	Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002

32.2‡	Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002

101.INS	XBRL Instance Document				X

101.SCH	XBRL Taxonomy Extension Schema Document				X

101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document				X

101.DEF	XBRL Taxonomy Extension Definition Linkbase Document				X

101.LAB	XBRL Taxonomy Extension Label Linkbase Document				X

101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document				X

	‡Furnished herewith

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	TOPBUILD CORP.


	By:	/s/ John S. Peterson
	Name:	John S. Peterson
	Title:	Vice President and Chief Financial Officer
		(Principal Financial Officer)

November 6, 2018