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Operator
Ladies and gentlemen, thank you for standing by.
Welcome to the Lennox International Second Quarter 2005 Earnings Conference Call.
At the request of your host, all lines are in a listen-only mode.
There will be a question-and-answer session at the end of the presentation.
As a reminder, this call is being recorded.
I would now like to turn the conference over to Bill Moltner, vice president of investor relations.
Please go ahead, sir.
Bill Moltner - Vice President of Investor Relations
Thank you, Christina.
Good morning and thank you for joining us for this review of Lennox International financial performance in the second quarter of 2005.
We are broadcasting today's call on the Internet, and there is a direct link to the webcast on our corporate website at www.lennoxinternational.com.
We will archive the webcast on our website and it will be available for replay.
This morning, Bob Schjerven, our chief executive officer, will comment on our Company's progress and performance in Q2, and provide an outlook for the balance of 2005.
Sue Carter, our chief financial officer, will review operating performance by business segment, as well address key income statement and balance sheet items.
We'll wrap up the call as we usually do with a Q&A session.
In the earnings release we issued before the market opened this morning and which is posted on our website includes several tables providing financial detail and, where appropriate, reconciliation to the financial metrics that Bob and Sue will discuss to generally accepted accounting principles or GAAP measures.
I'd like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements.
These forward-looking statements are subject to risks and uncertainties.
A list of these risks and uncertainties is included in our publicly available filings with the SEC and includes the impact of higher raw material prices, our ability to implement price increases for our products and services, the impact of unfavorable weather on the demand for our products and services, and the potential impact on operations related to the implementation of new NAECA efficiency standards.
These risks and uncertainties could cause our actual results to differ materially from those that we express to you today.
I would now like to turn the call over to Bob Schjerven.
Bob Schjerven - Chief Executive Officer
Good morning.
We're very pleased with Lennox International's profitability in the second quarter.
We achieved record second quarter net income of $45 million, or 64 cents per share.
This amount includes a gain on the sale of the remaining interest in our heat transfer joint venture, also charges to close our hearth products factory and relocate that production to Mexico, and also an unfavorable tax effect from a change in state tax law.
Sue Carter, our chief financial officer, will provide more detail on these items just a bit later.
Excluding these items, our income from continuing operations was $41 million, or 58 cents per share, also a record for second quarter profitability, and also 14 percent higher than the $36 million in the prior year same time frame.
Our total Company revenue of $868 million in the quarter was up 8 percent, or 6 percent when adjusted for foreign exchange.
Our Heating and Cooling businesses outperformed the industry with 10 percent sales growth reflecting both improved pricing and also market share growth.
While the quarter started out slowly, favorable weather patterns in June in many of our key domestic markets increased demand primarily for Lennox brand residential equipment, which is sold directly to installing contractors.
I think you've heard us often say that one of the advantages of Lennox's One-Step Distribution Model is that it does put us closer to the end market, and that certainly was evident in June performance.
The price increases that we've implemented are sticking, and in the second quarter, our manufacturing business has realized price improvement of nearly 5 percent.
This increase allowed us to fully offset approximately $19 million in headwind created by higher costs for steel, copper, aluminum, and related components.
The new 13 SEER minimum efficiency standard for residential air conditioning, which comes into effect next January, is a key area of focus for management in our Residential Equipment business.
As we have explained in the past, we are using the new NAECA regulations as an opportunity to not only comply with the new energy efficiency requirements, but also to standardize product platforms across our brands, and to integrate other functional and cosmetic improvements into those products.
Our activities to comply with the new standard are on track.
Favorable weather in June also supported solid profit improvement of Service Experts in the quarter.
The improvement in this segment continues to meet our expectations.
We're getting better at executing the business model at the service center level, and we're leveraging our marketing programs to centralization, and we continue to target our opportunities to lower the cost structure.
The business is well focused with over 75 percent of revenue in the quarter coming from service and replacement sectors of the residential and light commercial markets.
On a trailing 12-month basis, Service Experts is profitable, albeit modestly, and we believe that the business is on track to achieve a low single digit segment profit for the full year.
LII continues to be a strong cash generator, and we have continued to strengthen the balance sheet.
At June 30, we had reduced our total debt by $42 million from a year ago level, which is reflected in lower interest expense in the quarter.
And the balance in our asset securitization program was zero at the end of the second quarter, compared with a balance of $135 million in the program last year.
This amounts to an effective reduction of $177 million in the economic debt of our Company year-over-year.
Truly notable performance.
Based on our performance in the first half of the year, the programs that we have in place for profitable growth and our projected ability to cover commodity cost inflation through pricing actions, we are raising our full year earnings per share guidance from a range of $1.50 to $1.60, to a new range of $1.60 to $1.70 per share.
This earnings per share range represents a 15 to 22 percent improvement over the $1.39 per share from continuing operations before good will impairment in 2004.
Consistent with this outlook, we now expect that LII's revenue growth in 2005 to be in the high single digits, up from our expectations of mid-single top line growth earlier this year.
Sue will now provide you with some additional detail in our business segment performance and balance sheet improvement.
Sue.
Sue Carter - Chief Financial Officer
Thank you, Bob.
Good morning, and thank you for joining us.
Before I comment on each of our business segments, let me address the dynamics of higher commodity costs in offsetting price increases as it relates to all of our manufacturing businesses.
The price increases we have announced are sticking.
As Bob mentioned, we realized a little less than 5 percent in price improvement in the second quarter, and that increase did cover our raw material increases.
However, the price increases did not sufficiently cover both the inflation in other costs and the margin on the incremental revenue which negatively impacted segment profit percentages in the quarter.
Our Residential Heating and Cooling business certainly benefited from the hot weather in June in the Central U.S., Northeast, and Great Lakes regions.
Revenue increased 9 percent in the quarter to $435 million, with foreign exchange contributing 1 percentage point of the growth.
Sales of our Lennox brand, which is sold directly to installing dealers and therefore reacts quicker to changes in market demand, were particularly robust.
Segment profit increased 4 percent to $57 million, again driven by the Lennox brand with operating margins contracting 60 basis points to 13.2 percent.
Our Commercial Heating and Cooling segment had another strong quarter with revenue advancing 13 percent, or 12 percent adjusted for foreign exchange, to $171 million, driven by continued strength in sales to our domestic national accounts.
Demand in the U.S. and Canada continues to improve, but market conditions are more difficult in Europe where the market has contracted.
Segment profit declined 8 percent to $15 million with operating margins declining from 11.1 to 8.9 percent.
Factory efficiency in our domestic operations was less favorable as we ramp up production to meet the increased demand for our products.
In addition, we incurred expenses as part of personnel changes in our European operations.
Together, these factors reduced profitability in the quarter by approximately $3 million.
Service Expert Sales were flat in the quarter at $168 million, or down 1 percent when adjusted for currency fluctuations.
Segment profit increased substantially by 61 percent to $9 million, with operating margins expanding 210 basis points to 5.5 percent of sales.
Lower head count and cost reduction programs contributed about $1 million to the improvement, and the business also benefited from more efficient advertising and promotion spending and lower backed-out expense.
At the Direct to Consumer business much like our Lennox Residential business, Service Experts responds quickly to changes in market demand and benefited from the favorable weather in June.
This is the third consecutive quarter of year-over-year improvement in profitability of Service Experts, and we are encouraged by the trend we are seeing.
In our Refrigeration segment, revenue rose 8 percent, or up 4 percent in constant currencies.
Segment profit increased 4 percent to $10 million.
Improved performance domestically was offset by weakness in Asia Pacific region, where we incurred higher fixed cost to expand our distribution capabilities in anticipation of market growth that did not materialize.
Operating margins declined 40 basis points to 8.6 percent.
Our total debt at June 30 was $275 million.
As Bob mentioned, this was $42 million lower than it was at the same time a year ago.
Our debt to total capital ratio was a solid 35.4 percent, down significantly from 43.4 percent at the end of the second quarter of 2004.
And, keep in mind, that just over one-half of our total debt is in the form of convertible notes, the dilution of which is included in our earnings per share guidance.
We now have the strongest balance sheet since LII made its initial public offering six years ago.
Improved profitability and our focus on working capital continued to pay off in our cash flow performance.
We were cash flow positive again in the second quarter.
In the second quarter, our cash from operations was $30 million.
During the quarter we invested $14 in capital expenditures, and we decreased our asset securitization program balance by $5 million, resulting in free cash flow of $21 million for the quarter.
We continue to focus on working capital management, and we continue to make progress.
Our inventories at the end of the quarter were down $28 million, or 10 percent year-over-year.
Our operational working capital ratio as a percent of trailing 12-month sales was 18.5 percent.
Corporate expense in the second quarter was $23 million, up $1.5 million from last year.
Variable accounting treatment for equity-based compensation, expenses associated with management changes, and costs incurred to centralized aspects of our procurement function contributed to the increase.
Our total interest expense of $5 million was down $4 million, reflecting a lower debt balance and $2 million in fees related to debt prepayment that were included in last year's second quarter.
Let me address some of the unusual items that impacted the quarter.
First, we realized a $7 million after-tax gain primarily related to the sale of the remaining interest in our key transfer joint venture to Outokumpu.
The cash proceeds from this transaction were approximately $39 million, which we applied to the Company's short-term borrowing.
We incurred $1 million in after-tax charges to close our Burlington, Washington hearth products factory.
This consolidation went very smoothly and our production has been successfully relocated to Mexico.
Our taxes in the quarter were negatively impacted by almost $2 million due to a new state tax law.
Excluding these items, our effective tax rate on continuing operations was 37 percent, a rate we expect to maintain for the full year.
Finally, we incurred $200,000 in after tax discontinued operations expenses related to the Service Expert Centers that were sold last year.
Taken together, these items added just under $4 million, or 5 cents per share to our net income in Q2, and they are included in the full year guidance range of $1.60 to $1.70 that Bob provided earlier.
That concludes our prepared remarks.
At this point, we would be pleased to address any questions that you may have.
Operator
(OPERATOR INSTRUCTIONS) Our first question today comes from the line of Curt Woodworth with JP Morgan.
Please go ahead.
Curt Woodworth - Analyst
Yes, good morning.
Service Experts, can you talk a little bit about your expectations in the back half of the year for that segment given the pretty good performance this quarter?
Year-to-date you're running operating income about $3 million, and I would imagine that sales trends would be looking up in the third quarter.
And given that you still expect low single digit income this year, that would assume pretty much flat performance, or maybe up a little bit in the back half of the year.
I just would like to get a little bit more color around your outlook.
Bob Schjerven - Chief Executive Officer
This is Bob.
First of all, the low single digits expectation we have refers to the margin for that particular segment, the margin percent, and your comments relative to the improvement -- what shall we say, to the market generally, for example, your expectations certainly are shared by all of us.
I'll tell you this, this business is running very much to the improvement profile that we have laid out.
They are doing a good job and we said before that this is a journey.
Particularly with respect to all of the processes that have been put in place, we see ongoing evidence that the people at the center level are becoming more and more proficient in using these best practices and turning this thing into the kind of an operation that our expectations have long since supported our investment in that operation.
Curt Woodworth - Analyst
Okay.
And then on the residential business, can you talk a little bit about margin trends there?
I know you noted that you've got the $19 million headwind offset with price improvement, but does that mean you're not offsetting from the component cost increases and other incremental increases in terms of the margin rates being down this quarter?
Sue Carter - Chief Financial Officer
I think what that means, Curt, is exactly what you're talking about.
We covered the cost increases from the commodities that were tracking, but the reference to the profit margin decline comes in from other costs that we did not cover the inflation for those.
Curt Woodworth - Analyst
Is that mainly components, or what would those costs be?
Sue Carter - Chief Financial Officer
It could be several different things, but it could be labor, it could be overhead, period expenses.
Curt Woodworth - Analyst
Okay.
But it wouldn't include component cost inflation?
Bill Moltner - Vice President of Investor Relations
Curt, when we talk about the $19 million, we talk about copper, aluminum, and related components.
Cooper and aluminum is a major component.
We factor in the inflation for those components.
Curt Woodworth - Analyst
Okay.
Great.
And then in terms of the production ramp issues in the commercial HVAC segment, can you talk about a continuation of that into the third quarter?
Do you expect to have those issues resolved?
It would seem that if you're ramping production -- are you not getting the economies to scale?
Can I just get a little bit more color on what those inefficiencies actually were?
Bob Schjerven - Chief Executive Officer
The primary thing [inaudible], as we ramp up production, we saw the second quarter, the addition of a number of new employees, and you always have a learning curve associated with that.
You certainly double up with people who mentor the new people and help with job instructions and so forth.
So to go along with what I think was your first sentence of your question, it is certainly our expectation that we would see those things diminish in the third quarter.
Those kind of expenses always are heaviest in the first few weeks that you have the folks in and they mesh and become a regular part of the workforce actually quite nicely over a relatively short period of time.
Curt Woodworth - Analyst
Okay, great.
Thanks.
Then the last question quickly.
The $7 million gain in the Heat Transfer business, did that show up in the Corporate in another line, or is that just a separate line item?
Sue Carter - Chief Financial Officer
No, it's actually in a separate line item under Selling, General and Administrative as Gains, Losses and Other Expense.
Curt Woodworth - Analyst
Okay, great.
Thanks.
Operator
(OPERATOR INSTRUCTIONS) Next we're going to the line of Jeff Hammond with KeyBanc Capital Markets.
Please go ahead.
Jeff Hammond - Analyst
Hi, good morning.
Back to the Commercial.
Sue, you said it was a $3 million hit.
I guess, Bob, based on your comments, it seemingly that $3 million would be viewed as a one-time item, but also, Sue, could you quantify separately the two issues of the $3 million?
Sue Carter - Chief Financial Officer
What we talked about with the $3 million is that approximately one-third of the costs associated with that would be related to the personnel costs and other changes in our European operation, and the remainder would be the factory efficiency item.
Jeff Hammond - Analyst
Okay.
And then, Sue, corporate expense looks to be up about 4.5 million through the first six months.
If I recall, you had talked about in '04 about 15 million of kind of one-time items in corporate expense.
How should we look at corporate expense for the full year for the rest of the year on that basis?
Sue Carter - Chief Financial Officer
What I would say on corporate expense is the things that you're seeing in the first six months of the year is some increases in -- you know, again, what we talked about, the variable accounting treatment for some of our long-term incentive program, our procurement organization, and our ongoing SOX clock that would not have been as heavy at this point in time during last year.
As we move out into the rest of the year, which really relates to the -- what you're talking about last year with the one-time cost, we expect that we'll be relatively flat in those periods in Q3 and Q4 to last year.
Jeff Hammond - Analyst
Okay, great.
And then it looks like your inventory is in pretty good shape exiting the quarter.
Can you maybe just give us -- with that in mind and just given the warmer weather in July, can you just give us an update how your businesses might be trending into July?
Bob Schjerven - Chief Executive Officer
Well, July, everybody is impacted by the weather, I think, looking at the weather report and the news, and we certainly continue the top line good news to continue through the month of July based upon the weather forecast.
That obviously would be a general comment that would apply to the whole industry, I would think.
Jeff Hammond - Analyst
And then how about specifically the Service Experts.
Would they be benefiting from that as well?
Bob Schjerven - Chief Executive Officer
Well, sure.
When you've got a higher level of volume and deploy your people to a much more efficient basis and every one of those service calls that you make are an opportunity to upsell and do other things to improve the comfort of the consumer's home, so, yes, it's quite positive.
Jeff Hammond - Analyst
Okay.
And then, finally, you mentioned I think on a couple of occasions, you know, paying down debt, your balance sheet being in very good shape.
I just wanted to understand at this point, if you had to prioritize your uses of free cash flow going forward from here, how would you prioritize that in terms of dividend, share repurchase, acquisition priorities, paying down further debt, perhaps the convertibles?
Sue Carter - Chief Financial Officer
What I would say about that, Jeff, is that as we look at the cash that's on our balance sheet at the end of June, there is $93 million of cash on the balance sheet, we do have our captive insurance program, so there is some of that cash that is not available for operating usage.
That would take the cash down to about $66 million that's available for operations, and as we look at that cash, we're very comfortable that that cash as a percentage of our assets, which is about 4 percent, or is a percentage of our sales, is the right level for us in terms of flexibility within our operating unit, so we haven't gone out and publicly prioritized other uses, but what I can tell you is our management team is very diligent and we're looking very critically at what we do with our cash.
We'll be looking at all options to improve our balance sheet or grow the business, but our approach, really, is to be very, very prudent and make sure that we make the right decisions on the cash.
Jeff Hammond - Analyst
I guess, Sue, if you look at the seasonality of your business, you generally generate more free cash in the second half of the year.
So, I mean, I guess at what point are you able to share with better clarity where that free cash flow gets redeployed as it starts flowing in?
Sue Carter - Chief Financial Officer
My expectation would be that as we go through the remainder of 2005, we had all the changes and the flexibility that we said we desired in 2005, that when we get closer to 2006, that we'll be able to give more clarity.
But, again, I think from our viewpoint, the cash balance that we have on the balance sheet is something that we're very comfortable with in terms of just operating flexibility.
Jeff Hammond - Analyst
Okay.
Thanks, guys.
Operator
And next we'll go to the line of Michael Coleman with Southwest Securities.
Please go ahead.
Michael Coleman - Analyst
Morning.
I was wondering, you mentioned, obviously you had a slow start and June finished strong.
But I was wondering if you might be able to quantify just how strong or the difference between the first two months and the final month of the quarter, really some color on it?
Bob Schjerven - Chief Executive Officer
About the only thing, I guess, that we'll say, because we don't split things out, that's not our habit, is that if you look at the weather and a couple of different effects -- certainly the weather is one effect, and it made June a noticeably more strong than April and May, which were -- actually, May was rather disappointing when we looked at the weather and the impact.
The other thing that you saw as you looked at the entire industry was that for those people that are on the distributor level of the industry on the residential side, they had fairly significant -- in fact, record inventories as they went through the periods of April and May simply because of the slow start in the weather.
So to the degree that anybody is trying to fine-tune their models and so forth, I think that phenomenon should be taken into account.
Michael Coleman - Analyst
Okay.
I'm just curious, who do you think you might be taking market -- or you're taking share, but who do you think you might be taking market share from?
Bob Schjerven - Chief Executive Officer
Other people in the market.
Michael Coleman - Analyst
Okay.
In terms of the commercial refrigeration in Asia, I'm wondering if you can comment on the pricing and the competitive pricing in that market, if you've seen an increase in competitive pricing?
Bob Schjerven - Chief Executive Officer
Well, I know this.
To be very frank with you, I can't comment on that directly.
But looking in terms of margins and the impact, increased raw material, we've done a good job at covering both the increase that we've seen and the margin associated with that.
So from a recovery against higher material cost, the refrigeration folks have done a pretty decent job.
Michael Coleman - Analyst
Okay.
And relatively same question in terms of the commercial piece of the business.
Is that -- the competitive pricing front -- have you seen an increase in competitive pricing?
Bob Schjerven - Chief Executive Officer
Well, this is -- we've -- the pricing increases that we've put out there, which have been very close to 5 percent, those have stuck.
And there is one nature of that business that you probably are aware of, and that is on an ongoing basis, you have -- particularly with the amount of national account penetration that we enjoy -- you have a certain amount of fixed contracts for periods of time.
So as you go through the year and various of these contracts are renewed, then the appropriate increases in price have been applied.
So what you actually saw was in the increase in pricing over the last 18 months or so has been just a bit delayed as a rule, compared to the residential simply because of that factor.
And they don't obviously come in at the same time, sort of a staccato effect of each one of these contracts have their own expiration date.
Michael Coleman - Analyst
Okay.
And I was also wondering if you could quantify what the impact of the -- you had 13 cents from audit and Sarbanes-Oxley for the year, and how much of that was in the second quarter?
Sue Carter - Chief Financial Officer
For 2004, I think that -- let's see, I'm searching my memory -- I think it was about 4 cents that occurred in the second quarter of 2004.
Michael Coleman - Analyst
Okay.
Is that similar impact for the third quarter?
Bob Schjerven - Chief Executive Officer
In 2004 it was quite a bit higher in the third quarter than the fourth, because naturally all of the work that was being done around process vamping and so forth, as we were moving down the compliance trail, really drove those costs up noticeably in Q3 and in Q4 last year.
Sue Carter - Chief Financial Officer
Right.
They were escalating through the back half of 2004.
Michael Coleman - Analyst
Okay.
Thank you.
Bob Schjerven - Chief Executive Officer
Thank you, good question.
Operator
We have no further questions at this time.
Please continue.
Bill Moltner - Vice President of Investor Relations
Lennox International has performed well in the first half of 2005.
Our equipment businesses are growing, and we continue to effectively manage raw material headwinds.
Profitability improvement is meeting our internal expectations at Service Experts, and the business is on track for full year segment profitability in the low single digits for margin.
Our outlook is optimistic and we are raising our full year 2005 earnings per share guidance to a range of $1.60 to $1.70.
Thank you for taking the time to be with us today.
Operator
Ladies and gentlemen, that does conclude our conference for today.
We thank you for your participation and for using AT&T's Executive Teleconference Service.
You may now disconnect.