Lennox International Inc (LII) 2009 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Lennox International Q2 2009 earnings conference call.

At the host's request, 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 Steve Harrison, Vice-President of Investor Relations, please go ahead.

Good morning.

Thank you for joining us for this review of the Lennox International's financial performance for the second quarter of 2009.

I'm here today with Todd Bluedorn, CEO and Roy Rumbough, Interim CFO.

Todd will review key points on the quarter and Roy will take you through the company's performance.

In the earnings release we issued this morning, we have included the necessary reconciliation of the financial metrics that will be discussed to GAAP measures.

You can find a direct link to the webcast of today's conference call on our corporate website at www.lennoxinternational.com.

We will archive the webcast on that side to make it available for replay.

I would like to remind everyone that in the course of this call, to give you a bed better understanding of our operations, we will be making certain forward-looking statements.

These statements are subject to numerous risk and uncertainties that could cause actual results to differ materially from such statements.

For information concerning these risks and uncertainties, see Lennox International's publicly available filings with the SEC.

Lennox disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

Now, let me turn the call over to CEO, Todd Bluedorn.

Thanks, Steve.

Good morning, and thank you for joining us.

End markets remained weak in the second quarter, but strong execution enabled Lennox to generate $55 million of free cash flow in the quarter, up 26% from a year ago.

While the residential market continued to decline from a year ago, we saw the rate of decline slow in the second quarter.

In the commercial and refrigeration markets, however, we saw the rate of decline increase in the quarter.

Let's talk more about the residential market first.

Looking at AHRI data for North America residential, unit shipments in the second quarter were down 13% year-over-year versus second quarter last year.

This was a slower rate of decline than in the first quarter in which shipments were down 22% year-over-year.

In replacement business, we estimate a year-over-year decline in the mid-single-digits in the second quarter.

This compares with the year-over-year decline in the high single-digits in the first quarter.

On the new construction side, the year-over-year rates of decline slowed as well.

The National Association of Homebuilders last estimate was for single-family housing starts to be down 42% year-over-year in the second quarter compared to 51% year-over-year decline in the first quarter.

Moving on to commercial, AHRI data for North America commercial unitary market said unit shipments down 31% year-over-year in the second quarter.

This was an increased rate of decline from the first quarter in which the industry shipments were down 27% year-over-year.

We saw similar market dynamics for our refrigeration business in North America.

In Europe, commercial HVAC and refrigeration both saw faster rates of decline than what we saw in North America.

Looking at our financial results in this market environment, overall revenue was $791 million, down 17% at constant-currency and down 21% at actual currency.

Adjusted earnings per share from continuing operations was $0.67 compared to $1 .02 in the record second quarter a year ago.

On a gap basis, earnings per share from continuing operations was $0.63 versus $0.89 in the second quarter last year.

Cash generation remains strong as we aggressively manage working capital levels.

As a result, cash from operations was $66 million, 18% better than the second quarter last year.

Free cash flow was $55 million, 26% better than a year ago.

Working capital changes year-over-year contributed $24 million to cash generation.

A strong free cash flow performance in the first half at $61 million compares to $1 million in the first half of 2008, and reflects our ongoing focus on cash generation.

With such strong cash generation, we have strengthened our balance sheet further, paying down $85 million of debt during the quarter.

Total debt on the balance sheet stood at $320 million at the end of June and a debt to EBITDA of 1.3.

We continued to invest in the business with approximately $11 million of capital spending and are well positioned with our balance sheet to continue to enhance our premium position in the market.

Financial results in the second quarter were impacted by downed volume across all our end markets with offsets from cost reductions and improved price and mix compared to a year ago.

Lennox continues to aggressively manage its cost structure.

As previously communicated for 2009, we expect approximately $25 million incrementally in restructuring savings, $20 million in commodity savings and another $20 million in global sourcing savings.

We have a 12% salary headcount reduction in 2009 on top of the 7% reduction last year, for a total of 1,050 positions.

These headcount actions and other cost reductions provide $55 million in SG&A savings from our plans earlier this year.

While much of this savings is weighted to the second half of the year, benefits were clear in the second quarter.

Despite the significant revenue climb gross margins -- gross margin was up 120 basis points in the second quarter from a year ago.

Improvement was driven by positive warranty adjustments, favorable product pricing and mix and factory productivity.

SG&A was down 11% in the second quarter from a year ago.

Let's look at some key points for each of our businesses for the quarter.

In our residential business, we continue to see a mix shift in the second quarter to our Lennox high efficiency products of 14 SEER and above.

This was up 17 points from a year ago to 47% of our shipments.

We see the stimulus plan contributing to this ongoing shift to the high efficiency products due to the 30% tax credit, up to $1,500 now available for certain high efficiency HVAC systems.

As mentioned, the commercial unitary market in North America showed further signs of deterioration in the second quarter, as did our commercial HVAC business in Europe.

Lennox continued to win in the marketplace on the strength of our energy efficient rooftop systems.

Our focus on replacement continues to pay dividends as that business again grew year-over-year in the second quarter.

We signed three new national accounts in the quarter, bringing the first half total to nine and the total sense of start 2007 to 64 new national accounts.

K through 12 schools continue to be a bright spot with some positive effects coming from the stimulus package.

We expect the stimulus spending for other government buildings to start providing benefits later this year and more so in 2010.

We are well positioned with our Strategos product line, the most efficient rooftop in the industry as well as with the focused sales force to capture opportunities in these markets.

Like in commercial, our refrigeration business saw a further slowdown in the end markets around the world excluding China, which was up in the quarter from a year ago.

Refrigeration continues to win in the market with its new high efficiency products.

Recent customer wins include Price Choppers and Maynards.

In our North American supermarket business, customers continued to remodel their stores to lower operating costs, and our shipments were up more than 30% in the first half.

On the competitive front, Carrier sold its car refrigeration business to Hill Phoenix, one of our major customers.

Lennox has already begun to benefit from this.

With more than 80% of our service experts business in residential, we saw slowdown in the year-over-year rate of decline like in our residential business.

Service experts volume is down 11% year-over-year in the second quarter compared to 17% year-over-year in the first quarter.

Looking at cost and productivity initiatives, we have now finalized the rollout of hand held devices to technicians and are seeing an increase in revenue dollars per hour and other benefits.

Now let me turn it over to Roy to discuss our financial results in more detail.

Roy?

Thank you, Todd.

I'll provide some additional commentary on the business segments for the quarter starting with residential heating and cooling.

In the second quarter, revenue from our residential heating and cooling segment was $379 million, down 16%.

While volume was down 18%, price was up 3% and mix improved 1%.

Currency had a 2% negative impact.

The volume decline compared to the prior year was driven by a drop in new construction and softer replacement business as consumers remained cautious in this economic environment.

Segment profit in the second quarter was $39 million compared to a profit of $50 million a year ago.

Segment margin was 10.4% compared to 11.1% in the second quarter of the prior year.

Turning to our commercial heating and cooling business, in the second quarter, revenue for the commercial business was $163 million, down 29%.

Volume was down 29%, product mix up 4% and price was up 1%.

Currency had a negative 5% impact.

Segment profit was $19 million compared to $27 million in the prior-year quarter.

Segment margin was 11.9%, up 30 basis points from 11.6% a year ago.

Our Europe commercial HVAC revenue was down in the high 20% range at constant currency, and the business was in a loss position for the quarter.

Aggressive restructuring activities continue in Europe.

In North America, commercial HVAC revenue was down in the low 20% range at constant currency due to the overall new construction slowdown and market weakness.

Moving to service experts.

In the second quarter, revenue was $154 million, down 14%.

Volume was down 12%, price and mix were flat and currency had a negative 2% impact.

The volume decline compared to a year ago was driven by a decline in new construction and a weaker replacement business.

Segment profit was $9 million compared to $14 million in the prior-year quarter.

Segment margin was 5.7% compared to 8.0% a year ago.

In our refrigeration segment, revenue in the second quarter was $122 million, down 28%.

Volume was down 22%, price mix was flat and product mix was flat and price was up 3%.

Currency had a negative 9% impact.

At constant currency, sales were down in the mid-teens in North America, up double -- up low double-digits in China and down significantly in other international markets.

Segment profit was $10 million compared to $17 million a year ago.

Segment margin was 7.9% versus 10.3% in the prior-year quarter.

Looking at restructuring charges and other items from our continuing operations in the second quarter, Lennox had net after-tax charges of $3.4 million from restructuring activities and $1.3 million from unrealized gains on open futures contracts and other items.

These charges impacted our GAAP EPS from continuing operations by $0.04.

In discontinued operations, the company took an after-tax charge of $4.2 million or $0.07 per share related to litigation involving a service expert service center that had been sold in 2004.

Corporate expenses were $15 million in the second quarter compared to $9 million in the prior year.

The year-over-year comparison is affected by a $5 million one time positive foreign exchange adjustment in the second quarter of last year.

Adjusting for that item, corporate expenses were up slightly.

Our full year 2009 corporate expense guidance is unchanged at $60 million.

Overall, SG&A was a down 11% in the second quarter versus the prior year, driven by headcount reductions and cuts in discretionary spending.

Our cash from operations in the second quarter was $66 million compared to $56 million in the prior-year quarter.

For the first half, cash from operations was $83 million compared to $24 million in the prior year.

Capital spending in second quarter was approximately $11 million versus $13 million a year ago.

Free cash flow in the quarter was $55 million compared to $44 million in the prior-year quarter.

As Todd mentioned, we had strong cash generation in the second quarter due to a $24 million year-over-year improvement in working capital.

Free cash flow was also favorably impacted by the return of the collateral we had posted for copper hedges in 2008.

In the fourth quarter of last year, we posted $38 million in cash as collateral for copper hedges.

This amount has now been essentially returned with $24 million coming back in the first quarter and another $13 million in the second quarter.

Working capital balances improved on a year-over-year basis by $130 million.

Our 12-month average working capital as a percent of trailing 12 months sales was 18.7% compared to 18.4% in the prior-year quarter.

The quarter end working capital balance as a percent trailing 12 month sales was 18.0% compared to 18.7% in the prior year quarter.

Taking a look at liquidity, cash and short term investments were $99 million at the end of June.

Our debt to EBITDA ratio was 1.3.

Our total debt on the balance sheet was $320 million at the end of the quarter.

We have a $650 million revolving credit facility in place through 2012.

We also have a $125 million asset securitization facility in place and our utilization remained at $30 million in the second quarter at excellent rates.

We also have $34 million of subsidiary credit facilities in place.

In summary, Lennox is well positioned from a liquidity perspective and has a strong balance sheet to advance our strategic objectives.

Now, let me turn the call back over to Todd to discuss our outlook for 2009.

Thanks, Roy.

Well, we saw the year-over-year rate of decline slow in the second quarter for our largest end market residential.

The rate of decline increased year-over-year for commercial and refrigeration.

We expect the second half of 2009 to remain challenging.

On the residential side, the North American Home Builders last estimates call for North America single-family housing starts to be down 36% for full year 2009.

Our best estimate for the replacement market is down mid-single-digits.

There is much uncertainty around the replacement market, more so than any time that I can remember.

Replacement market results will be driven by consumer confidence, consumer financing and as much as we hate to admit it, weather for the balance of the year.

July has started off cooler than normal and cooler than a year ago in many parts of the country.

For the overall residential market, we still expect a decline in the mid-teens for 2009.

In commercial HVAC, we continue to see deterioration in the end markets.

We continue to expect the North American unitary market to be down in the mid-20% range for the year, and we now expect the markets we serve in Europe to be down in the low 30% range.

In refrigeration, North America continues to be soft while international markets have deteriorated further, excluding China, which we expect to be up in 2009.

As offsets the full-year savings of $20 million from lower commodity prices, $20 million from global sourcing and $55 million in SGA versus the plan earlier this year are all weighted more to the second half of 2009.

And we will continue to see benefits from the $25 million in restructuring savings in total for 2009.

Based on the results to date and market conditions expected through 2009, we are narrowing our revenue and earnings per share guidance to the low end of our previous range.

We expect revenue to be down 17% to 19% for the full year, including a 3-point impact from foreign exchange.

We expect adjusted EPS from continuing operations to be $1.65 to $1.80, with the third quarter facing a difficult comparison to the record quarter a year ago.

GAAP EPS from continuing operations for 2009 is expected to be $1.38 to $1.53.

Our share count assumption is 56 million to 57 million shares for the full year.

Our tax rate is expected to 36% to 37% and we expect capital spending of $75 million in 2009, focused on new product introductions and transformational investments in the business.

With that, let's go to Q&A.

(Operator Instructions) We'll go to our first question from the line of Steve Tusa of JPMorgan, please go ahead.

Hi, good morning.

Hi, Steve, how are you?

Good, thanks for all of the detail.

I'm not sure I heard you at the end there.

Did you give a view on the replacement market for this year, or did you just give a total (inaudible) down in mid-teens?

I want to make sure I gave you the exact thing I said.

We gave guidance on replacement market.

We said our best estimates for replacement market is down mid-single-digits for the year.

And that was it high single-digits previously?

I believe it was high single-digits previously.

What's changed?

Is it basically the better May, or what has changed in that guidance?

As you know, second quarter is our largest quarter, and the fact we had that come in down mid-single-digits gave us confidence for full year that we would expect the second half of the year to be similar to the second quarter.

Okay.

Great.

And then on the -- on mix and price, I'm just curious.

Mix was, I think you said a percent in the quarter in resi, and it has been running a little bit better than that, I guess, over the last couple of quarters, correct me if I'm wrong.

Any change in the dynamic there?

I would have thought that would have held up as more of a positive factor than this 1%, given the stimulus?

I don't think there is any major change.

I think there was new construction that the quarter as some of the housing picked up a little bit in the second quarter, and we saw that sort of flow through our number, which typically is a little bit lower margin.

Also, to the highest level of logic we've talked about before is there is this bifurcation taking place, which is middle market moving up and middle market moving down, and so there is offsetting head winds and tail winds in the business.

Would you expect, is 1% is a good number to think about over the next couple of quarters, or would you expect that to get back to more like the 2% to 3% we've seen over the last couple of years?

I don't I don't think I would take one quarter and extrapolate it.

I think for my models, I would take what we have seen before and sort of lay it out, with the caveat, as R&C starts to pick up and become a larger part of our mix again, I think there may be pressure on the mix line.

And then on the warranty, how much of that came in resi?

Just to get the year-over-year, so $6 million year-over-year benefit.

How much of that would have come in resi?

On the $6 million year-over-year benefit, roughly 75% was res and 25% was commercial HVAC.

Okay, great.

And then one more thing.

You sound like -- you sound pretty confident with, given you guys have pretty good connections with the builders and housing that we've kind of seen the worst there in housing.

I know everybody is trying to call that, but I'm just curious as to -- with your tone, it seems like you're pretty positive on that?

I'm officially not calling a bottom.

I think what we're seeing is quite frankly, is -- not in any of our conversations with builders, but we're extrapolating what others are saying and others are seeing.

I don't think we're alone on saying that there appears to be -- things were incrementally better than what they were in earlier in the year, and that is what we're reflecting in our numbers.

And so our guidance for the full year of improved -- it is still down mid-30% year-over-year on starts, but it's better that it -- at least the forecast is better than it was a few months ago, and we're just taking that from the North America Home Builders.

Okay, sorry, one more quick one here, just on price, continue to get a good amount of base price, I guess.

How do we think about that as we move through the year?

When was the last price increase?

And do you see -- I know Carrier mentioned some underlying price pressure possible through the second half of the year.

How do you think about price going forward?

Last year we announced a mid-year price increase about this time last year in response to steel shocks.

Much of that has stuck.

But obviously, the comps get more difficult during the second half of the year, and we're starting to see on the margins some pricing pressure.

That being said, we're cognizant that commodities have moved dramatically over the last two years, both up and down.

I think there are many economists who are concerned about inflation, and so we're cognizant of avoiding giving price back in the uncertainty in the marketplace.

So the comps are harder year-over-year.

We're seeing pricing pressure on the margins, but we're committed to hanging onto the price we have in the marketplace.

Great.

Thanks for taking all of my questions.

I appreciate it.

Thanks.

Our next question comes from the line of Robert Wertheimer with Morgan Stanley, your line is open.

Hi, good morning, everybody.

Hi.

So, a couple of questions.

One, your inventory control was very tight in the quarter, and I would like to see how you're thinking about that from a structural sense.

Do you reach a point where you can't trim it any more?

It's obviously been very good, and at what point do you think about, you have to invest in that for next year, when that rolls around, or can you maintain these low levels more structurally?

I think it flows with the volume.

In other words, we will continue to focus on getting turn improvement on our inventories as continuous improvement, but a large degree why our working capital is down 22% is the markets are down 20% and our volumes are down 20% and so as we reinflate the business, inventory will grow.

On the warranty, is that sort of structural improvement in quality?

Can you give a little bit of background on that?

Yeah, we review and adjust our warranty reserve annually, and the adjustment we made this quarter, just like the adjustment we made second quarter last year is based on continuing improvements and product quality and reliability, and that is what we reflect.

Perfect.

If I can ask one last one more generally.

Do you have a sense from interaction with consumers, one, whether credit has been an increasing problem and, two, whether there is increasing pent-up demand as people Band-Aid units or call in for fixes and don't do the right repair or replacement?

I'll do the first question first.

On financing, so far, so good.

We have a relationship with GE Capital, GE Money, that our dealers use to provide financing to our residential consumer customers.

And back at the end of last year, that started to tighten both the minimum FICA store and the amount they were willing to lend.

We seen it normalize during the first half of this year.

So at least from where we sit, the financing and our dealers provide our customers is about where it was a year ago, maybe a little tighter, but still in pretty good shape.

And what was the second question?

The second question is just a more general one, Whether you can tell from your interaction --

Yes, the dynamics of repair versus replace, from our perspective is where it has been for the last year and a half, two years, maybe even longer, which is with unemployment inching towards 10%, and consumer confidence still at low levels, people are avoiding making investments in their homes if they don't have to.

And so we've seen pressure in a move towards repair versus replace.

And that clearly creates pent-up demand, and when consumer confidence comes back and unemployment levels out, I think we'll see that in replacement numbers.

But given my forecast on guidance on replacement, year-over-year, we're not sure we're going to see that this year.

Yes.

Thanks a lot.

Thanks .

Next we have a question from the line of Keith Hughes of SunTrust.

Please go ahead.

Yes, I just want to ask on the European commercial business, we've been hearing about restructuring for a while, still losing money in the business.

Where are you in your restructuring plan and any specifics you can give us of what you're trying to do at this point.

Yes Keith, it's unfortunately a moving target in Europe.

A year ago, we thought -- we had a profitable year in Europe after some significant restructuring, both on distribution and on the factory side, and we liked the business that we had there.

The market is down there 30%.

So you can imagine our volume is down with that.

And so the break-even has gone down significantly in Europe, and so we continue to restructure our distribution and look at restructuring our factory footprint, and we're going to continue to drive on both sides of that.

Is the problem more in distribution at this point?

I think it is both places, Keith.

I think -- I've talked before about distribution where quite frankly, we were too widespread and had too much fixed investment and distribution to support our volume.

So we've cleaned some of that up in large parts of Europe, specifically northern Europe.

We need to do more of it in the other parts of Europe, and we're doing that.

But we also have opportunities on our factory footprint and in our headcount, and we're addressing those.

Okay.

Moving over to the transaction you mentioned between, I think it was Tyler and Hill Phoenix.

How -- could you outline for us how that is going to affect your business moving forward?

Tyler is, as you know, a display manufacturer, was a competitor of Hill Phoenix who bought much of their refrigeration equipment from Carrier companies.

That customer base is now part -- is being served by Hill Phoenix after the acquisition of assets of Tyler Refrigeration.

And Hill Phoenix is one of our largest and important customers.

So we're working on supplying solutions for them, for business that did not used to be ours.

All right.

Thank you.

Thanks.

Next, we have a question from the line of Jeff Hammond with KeyBanc Capital Markets, please go ahead.

Hi, good morning.

Hi, Jeff.

Todd, can you just walk through -- you've consistently talked about the three buckets of savings.

Can you just talk about where you're at year-to-date on getting those, and I guess I can back into what you're getting in the second half.

I'm not going to be as specific, probably, as you want me to be, Jeff.

On commodity savings, the majority of that is second half of the year, and I think you know that on your own, right?

Given the steel price increases took place mid-year last year, and given our hedge positions, we're going to see the vast majority of those benefits second half of the year.

On global sourcing savings, majority second half of the year, although we've seen benefits during the first half.

And the restructuring savings, I would tend to view that as spread roughly evenly throughout the year.

Okay.

And then any kind of preliminary thoughts as you look into 2010?

As you look at those buckets, do you get -- at today's prices do you get incremental commodity deflation, and what do you think you can get on the sourcing front into next year, and just based on your actions and maybe some help from Mexico plant, what might you get on restructuring?

Again, I'm not going to go down the path on 2010 guidance probably as much as you would like me to.

So I'll repeat some things I've talked about publicly.

On our sourcing initiative I've talked pretty publicly about how I thought we could get a 5% annualized savings and if this was our first year and next year we would have more of a normalized 5% number, which roughly the volumes are now order of magnitude $40 million, and we've talked about that.

Having given much guidance on commodities and we continue to restructure, and so restructure will be sort of every year I think will be continued savings, and we still have more things we're going to do this year and as we make those public, then it will be clear what the pieces are and how they fit together next year.

Is 2010 the year you start getting benefit from the Mexico plant?

Or are we still at too low of a volume level to see that?

I think we start to really generate the savings in Mexico in 2011, but at least from prior guidance that we've given, we still need to sit down and make sure we understand what 2010 looks like from a volume viewpoint.

But obviously, the big savings in Mexico's on labor arbitrage, and we need volume to flow through the factory to do that.

The major product lines that are there right now, although we continue to move more, is our Mare product line, which is focused on the R&C market place, residential and new construction marketplace.

And so as that market recovers, then we'll see -- continue to see increased volume in our Mexico facility.

As you also know, we moved some of our Allied product from South -- are in the process of moving Allied product of South Carolina down to that factory, also.

Moving to the commercial businesses, can you speak to what you're seeing on order rates relative to shipments, book-to-bill for both the commercial heating, cooling and refrigeration business?

Our lead times aren't that long.

So from a broad perspective, you can look at our revenue and sort of piece together what our -- what's happening on our order rates.

There is not a significant difference between the two across the -- our commercial businesses.

We don't have the large backlog like the apply business.

And what's your experience been more recently on cancellations, deferrals?

We haven't seen much cancellation and deferrals.

We've just seen --- sort of the dynamic was significant slowdown starting at the end of last year and continue quarter -- year-over-year quarter-over-quarter deterioration in the end markets.

So as I talked about, we -- from AHRI numbers, unitary business in second quarter in the US was down 31%, and I think -- we obviously did better than that, and that reflects our share gains, both in national accounts and replacement, but the markets are tough right now.

Okay.

And then CapEx, you run less than $22 million through the first half.

Do you have some big capital projects planned for the second half?

Or is that $75 million number a little stale?

We still think $75 million is probably close to the right number.

The short answer is we do have some things queued up the second half of the year that quite frankly, we wanted to see how our cash position shook out before we spent the money and given the very strong first half of the year in cash, we're comfortable releasing some of those projects and we'll in fact do that, because it is the right thing for the business.

Okay, and then the follow-on, you've been aggressive in debt paydown.

Is that -- when do you start thinking about shifting capital priorities to share buyback or acquisitions from debt paydown?

I'll give you the standard answer, right, the three things we look at, investment in the business, giving it back to shareholders or M&A.

There has been lots of uncertainty about the marketplace.

I think it's starting to be a little bit more solid, whether we like it or not, but a little bit more solid in our understanding of the marketplace and as that solidifies, then I think we'll be more open to uses of cash.

We've said very clearly debt to EBITDA one to two, it's now 1.3.

And so I think that signals that we'll be looking at the balance sheet as we continue to generate cash.

Okay.

Thanks, guys.

(Operator Instruction) For our next question we'll go to the line of [Emacaloda Arlin] with Sterne Agee.

Please go ahead.

Good morning, it's Mike Coleman.

A couple of questions.

Mike, how are you?

I'm doing well.

The first one, you talked a lot about the potential of pent-up demand with a lot of repair and deferment.

Todd, when you think about an environment where pent-up demand is realized, is it in an environment where you're achieving low single-digit volume growth or mid-single-digit volume growth?

What were the two options again?

I guess the -- is the pent -- if you realize pent-up demand, is it more on the order of something as high as mid-single-digits, or is it more of a low single-digit type?

When you think about if you realized pent-up demand opportunity --

I think I said -- like we've said, we believe there is significant pent-up demand in the residential market and over the next few years, it will flow back.

As you can imagine, lots of variables that are going to effect that.

One is how much deferment has taken place, but then there is also issues around some of the things that may or may not happen from government legislation around minimum efficiencies and around cap and trade.

And so there is lots of variables effect on that.

The honest answer is that we don't have a firm model that we've built fort next three years.

When we talk about 2010 in December, we'll have a crisper point of view of what we think the replacement market is going to be there for there, and we'll also talk about our three-year longer term guidance and I think we'll have some more perspective then about how we think it might come back.

The honest answer right now is we continue to be focused on the current market conditions which are challenging and ensuring execution on our cost savings and productivity.

Okay.

And you addressed pricing in term of cautious about being aggressive in light of the potential of inflation.

And I'm just wondering if you could remind me or talk about your purchased materials as a percent of your cogs, what the kind of level is, or the big components?

Yes, if you look at our cost of goods sold, we're about 75%, 80% material, and out of that piece that is material, 40% or so are raw materials like copper, steel and aluminum and the balance are components that we buy from others.

Okay.

One -- on the warranty, do you anticipate warranty benefit in the back half of the year?

No, we -- just from an accounting point of view, we look at this and touch this thing and I'm looking at our chief accounting officer who is also our interim CFO, we officially look and touch this thing once a year, which is our second quarter review.

So we had positive news last year, which reflected improved quality and reliability.

We had positive news this year which reflected improved quality and reliability.

And so sort of adjustments to warranty of an ongoing basis will be a specific customer and product issues between now and next year, not our overall warranty rate.

Okay.

And you mentioned that the third quarter comparison is fairly difficult and that you have some accelerating benefits on the materials.

Is the biggest benefit on the materials side of it coming in the fourth quarter?

Yes.

Okay.

And so I guess looking at last year's fourth quarter, you had an accounting change for vacation policy, which helped the fourth quarter last year that would imply a difficult comparison, but your materials benefit is heavily weighted in the fourth quarter, then, to help offset that?

I'm not going to give quarterly guidance, or at least I won't go too far down that path.

I'll just restate what I said, which is our commodities are more towards the second -- vast majority are towards the second half of the year, more fourth than third, and then our material cost reductions, the majority are second half of the year and again more fourth than third.

Okay, great.

Thank you.

Thanks .

Next we have a follow-up question from the line of Steve Tusa with JPMorgan.

Your line is open.

Yes, just one more quick one.

On the -- following on the commodities question.

How positive was price costs this quarter, and I assume that you expect that dynamic to decelerate a bit in the back half as price rolls down a little bit, or maybe the commodities follow the same direction.

Can you just maybe talk about that price cost spread, whether it's gotten better or worse or how it stands after we've completed the first half here?

The honest answer is, Steve, I don't have the exact math in front of me.

Commodities were still a head wind year-over-year in the quarter.

Commodities were still a head wind year-over-year through the first half of the year and then prices, you see have visibility of what we've done on price.

And then in the second half of the year that flips the other way.

We're not getting the price, but we'll start to get commodity tail wind.

Right, okay.

All right.

Thanks a lot.

Thanks.

And at this time there are no further questions in queue.

Please continue, Mr.

Bluedorn.

Okay.

Great, thanks, Operator.

End markets were difficult in the second quarter, but generation was strong.

In the second half, we realized more benefits from our cost savings initiatives and year-to-year comparisons become easier in the fourth quarter.

However, market conditions remain challenging.

We continue to focus on strong execution through this downturn while continuing to position the company for strong earnings leverage as end markets recover.

I want to thank everyone for their interest and joining us on the call.

Thanks.

Ladies and gentlemen, that does conclude today's conference, thank you very much for your participation and for using AT&T Executive Teleconferencing.

You may now disconnect.