Lennox International Inc (LII) 2011 Q3 法說會逐字稿

Welcome to the Lennox International third quarter 2011 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 conference is being recorded.

I'd 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 Lennox International's financial performance for the third quarter of 2011.

I'm here today with Todd Bluedorn, CEO and Bob Hau, CFO.

Todd will review the key points on the quarter, and Bob will take you through the company's financial performance and outlook.

In the earnings released 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 site and make it available for replay.

We'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 statements are subject to numerous risks 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 all for joining us.

Let me take you through a few key points on the third quarter, and then Bob will discuss the financial results in detail, and the outlook.

Total company revenue was up 13% in the quarter.

Including the Kysor/Warren acquisition, excluding the acquisition and at constant currency, revenue was up 2%.

We saw volume growth across all of our equipment businesses, with commercial and refrigeration also benefiting from improved price and mix.

Residential at favorable pricing also, but again saw a mix down compared to a year ago.

In our service business, residential revenue was down while commercial revenue was up for the quarter.

Even margin of 7.4% was down 140 basis points.

Margin was impacted primarily by higher raw and component commodity costs as well as lower mix.

These were partially offset by a favorable price and at a two point improvement of SG&A as a percentage of sales.

Adjusted EPS from continuing operations was $0.80 versus $0.83 in the third quarter a year ago.

GAAP EPS from continuing operations was $0.64 versus $0.76 in the prior year quarter.

Looking at each business in the third quarter, let me start with residential.

The uncertain consumer environment continued in the third quarter as reflected in consumer confidence which dropped from 59 in July to 45 in August and stayed there in September.

However, weather helped in the quarter.

In July, weather was both warmer than normal and warmer than last year.

For the third quarter overall, cooling degree days were above normal but in line with the third quarter last year.

Residential revenue was up slightly at constant currency in the third quarter and segment margin was down 280 basis points to 7.7%.

While volume and mix were up, the dynamics we have seen around mix this year continued, leading to the mix down on a year-over-year basis.

As we have talked about previously, the expiration of the federal tax credit at the $1,500 level for high efficiency HVAC equipment and the re-emergence of R-22 outdoor condensing units in the market have negatively impact product mix.

In complete HVAC system selling, both for us and for the industry in general.

In total for both our Lennox and Allied brands, 37% of cooling product shipments in the third quarter were 14 SEER and higher down nine points from a year ago.

Conversely, 13 SEER was 63% of shipments in the third quarter this year.

R-22 was up from virtually nothing from a year ago to just under 20% of cooling product shipments in both the second and third quarter of this year.

Our residential business saw double digit growth in cooling product shipments year-over-year in the quarter, gas furnace shipments were down low single digits as the attached rate for complete HVAC system sales continued to lag.

To help offset the year-over-year headwind against complete HVAC system sales, we have repackaged our promotions and incentives, both at the dealer and consumer levels to encourage more complete system sales.

This does not mean more dollars, but a repackaging around the promotions and incentives we always have had in the market.

We are also well-positioned moving into the heating season with a more complete lineup of our new furnace platform across the various SKU's this year.

Our new furnace in the market have been standardized on a cost reduced 33-inch platform and range from highly competitive entry level furnaces, all the way up to the most premium in the market leading energy efficiency and performance.

It is still early in the furnace selling season and we need winter to set in across North America to drive volume.

Our service expert business saw the same dynamics in residential as on the premium side of our residential equipment business, a mix down and fewer complete HVAC system sales.

Again we have repackaged for most promotions and incentives to help counter these effects and compete more effectively across the HVAC market spectrum.

In our commercial service business, we saw 6% revenue growth, overall for service experts segment revenue was down 5% at constant currency and margin was down 30 basis points to 3.7%.

Turning to our commercial equipment business segment, revenue was up 10% at constant currency.

We saw broad-based growth across our business in New York America led by strong replacement business at national accounts.

Revenue from both replacement and new construction business was up double digits in the quarter.

Favorable mix was driven by the success of our high energy efficient rooftop, Energence and [stratagost] with national accounts.

We won five new national accounts in the third quarter, bringing our year-to-date to 14.

Since the start of 2007, we've won 89 new national accounts.

Europe revenue was up low single digits at constant currency, and we saw solid growth in both Eastern and Western Europe and continue to expand our geographical reach in the region.

Commercial segment margin was up 30 basis points to 14.4% on favorable volume, price and mix, and lower SG&A that combined to more than offset commodity headwinds year-over-year.

Now refrigeration business for the third quarter, revenue was up 59%, including the Kysor/Warren acquisition.

Organic revenue of constant currency was up 4% after adjusting for the strategic exit of the third party coil business in Australia last year.

Europe continued to lead growth would strength in both food and non-food refrigeration and was up double digits.

Refrigeration segment margin was up 20 basis points, excluding the impact of the Kysor/Warren acquisition.

Refrigeration volume growth and favorable price and mix more than offset commodity headwind in the quarter.

Let me shift gears and talk about what we're seeing on the commodity and component front overall, and the latest on price.

For 2011 we continue to expect raw and component commodity headwinds of $60 million to $65 million.

We continue to capture price in the market and still expect to realize $50 million more this year over last year.

Our most recent pricing action was last week when we announced a new 1% to 6% increase in our Lennox commercial business effective December 5th.

Regarding cost reduction initiatives, we are still on track with sourcing savings of approximately $25 million in 2011.

Turning to 2012, let me make a few points on the year now, and then is as our standard practice, we'll give specific details at our annual analyst day, which will be on December 14th in New York.

Looking to next year we are obviously facing uncertain markets, mix and commodity prices.

Most important is the micro economic overhang which is uncertain.

Given the overall market uncertainties, we're taking cost actions and ensuring contingency plans are in place for different scenarios that may develop.

We've had great success in material cost reductions over the last few years as we source more of our components from agent suppliers and created a more competitive supply base.

As we have talked about before, the material cost reductions will come increasingly from platform and system redesigns that take costs out.

About nine months ago we stepped up the engineering focus on these type of cost takeout programs.

We're excited about the progress we are making and expect to have similar cost reductions in 2012 from engineering-led programs as we've had from moving our supply base to Asia over the last three or four years.

We have also undertaken further restructuring actions at the company, including moving production to lower cost factories and structural reductions in SG&A.

We expect programs that are currently announced to provide a pre tax benefit of $7 million in 2012.

In SG&A, through a combination of restructuring and closely controlling discretionary expenditures, spending will be essentially flat this year with 2010.

On a long-term basis we target SG&A to grow at half the rate of revenue growth as markets come back.

One final point before I turn it over to Bob.

The Company has strong cash generation in third quarter with free cash flow of $132 million.

We paid $10 million in dividends and we repurchased $55 million of stock in the quarter.

Through the first ninth months of the year, we paid $27 million in dividends and repurchased $90 million of stock.

Given the recent stock price and the Company's strong cash generation, we're increasing our share repurchase plans for more than $100 million to a target of $100 (sic -- see press release) million for the full year.

Now I'll turn to over to Bob.

Thank you, Todd.

Good morning, everyone.

Let me provide you some additional commentary on the business segments for the quarter, starting with residential heating and cooling.

In the third quarter, revenue from residential heating and cooling was $374 million, up 1%.

Volume was up 4%, mix was down 5%, and price was up 1%.

Currency had a one point positive impact.

Residential segment profit was $29 million compared to $39 million in the prior year quarter.

Segment profit margin was 7.7% compared to 10.5% in the third quarter last year.

Results were primarily impacted by lower mix and a higher commodity cost, with offsets from higher volume, price realization and lower SG&A.

Turning to our commercial heating and cooling business.

In the third quarter, commercial revenue was $199 million, up 13%.

Volume was up 3% and price and mix were up 7%.

Currency had a three point positive impact to revenue growth.

Our North American commercial HVAC revenue was up mid-teens and Europe commercial HVAC revenue was up low double digits.

Commercial segment profit was $29 million, up 15% from $25 million in the prior year quarter.

Segment profit margin was 14.4%, up 30 basis points from 14.1% in the third quarter last year.

Results were primarily impacted by higher volume, favorable pricing mix and SG&A with an offset from higher commodity costs.

Moving to our service experts business.

In the third quarter, revenue was $145 million, down 4%.

Volume was down 7%, and price and mix were up 2%.

Currency had a one point positive impact.

Segment profit was $5 million compared to $6 million in the prior year quarter, and segment profit margin was 3.7% compared to 4.0% in the third quarter a year ago.

Results were primarily impacted by lower residential volume with offsets from strong growth in commercial services and overall lower SG&A expenses.

In our refrigeration segment, revenue in the third quarter was $224 million, up 59% including the impact of the Kysor/Warren acquisition.

Adjusted for the strategic exit of the third party coil business in Australia last year, organic revenue was up 11%, volume was up 2%, and price and mix were up 2%.

Currency had a positive seven point impact.

Segment profit was $21 million compared to $17 million in the prior year quarter.

Segment profit margin was 9.2% including the effect of the Kysor/Warren acquisition versus 12.3% in the third quarter last year.

Excluding the acquisition, refrigeration profit margin was up 20 basis points over the prior year quarter.

Overall, refrigeration results were primarily impacted by a higher volume and favorable price and mix, with offsets from higher commodity costs and higher SG&A, including the acquisition.

Looking at special items in the third quarter, the Company had an after tax restructuring charges of $6.7 million largely related to corporate and SG&A structural changes, as well as headcount reductions changes.

We expect (technical difficulty) $7 million of pre-tax benefit in earnings in 2012.

Corporate expenses were $15 million in the third quarter, flat with prior year quarter.

For the full year, we now expect corporate expenses to be $55 million to $60 million versus prior guidance of $60 million.

Overall SG&A was $166 million in the third quarter, up just under 2% from the prior year quarter.

For the third quarter, cash from operations was $140 million, double the $70 million in the prior year quarter.

Capital spending was approximately $8 million in the first quarter compared to $10 million in the prior year quarter, and free cash flow was $132 million up 122% from $59 million a year ago.

Due to the seasonality of our business, most cash generation takes place in the second half of the year.

Excluding the impact of the Kysor/Warren acquisition, working capital as a percent of trailing 12-month sales for the company was 18.5%, up from 16.7% in the year ago period.

The quarter end working capital ratio was 17.6%, down from 18.9% at the end of the third quarter a year ago, as we begin to work down inventory in the second half of this year.

Looking at liquidity, cash and cash equivalents were $58 million at the end of the quarter and our debt to EBITDA ratio was 2.0 with total debt of $500 million at the end of the quarter.

On October 21, the Company extended the maturity on its $650 million senior unsecured revolving credit facility from October of 2012 to now, October of 2016, through an amended and restated agreement.

Before I turn it over to Q&A, I'll briefly talk about our market assumptions for the full year of 2011.

In residential, we now expect industry shipments to be up mid-single digits for the year in total versus our prior view of low single digits.

But as we've discussed before, the lower impact of R-22 and the lower tax incentive is driving a significantly negative mix year-over-year for 2011.

We still expect the refrigeration market to be up mid-single digits, and we now expect the North American commercial unitary market to be up low double digits versus our previous expectation for the industry to be up high single digits.

Based on these assumptions and with one quarter to go in 2011, our guidance for organic revenue for the full year is now flat to up 2%, including two points of positive foreign exchange impact, versus the prior range of up 1% to 4%.

Including the Kysor/Warren acquisition, on an as reported basis, our revenue growth guidance range is now 7% to 9% versus the prior range of 8% to 11%.

Commodity headwind in 2011 from the increases in raw and component material remains $60 million to $65 million, partially offset by $50 million of price.

As Todd mentioned, we've announced an additional 1% to 6% price increase in our Lennox commercial business effective December 5th.

We are narrowing our 2011 guidance for adjusted EPS from continuing operations to a range of $2 to $2.15, compared to a prior range of $2 to $2.30.

Including the impact of announced restructuring activities, our GAAP EPS guidance moves to a range of $1.78 to $1.93 from the prior range of $1.93 to $2.23.

Our weighted average share count for the full year of 2011 is expected to be approximately 53.5 million shares and for the full year 2011 tax rate we now expect approximately 33.5%.

Capital spending for 2011 is expected to be between $45 million and $50 million, versus prior guidance for approximately $60 million.

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

Thank you.

(Operator Instructions).

Operator, maybe, before we go to Q&A, I've been informed that I got so excited about the stock repurchase plan that I misstated, so let me reread from my script the final sentence.

Given the recent stock price and the Company's strong cash generation, we are increasing our share repurchase plans from more than $100 million to a target of $120 million for the full year, so our target's now $120 million versus $100 million.

Okay, operator, let's go to Q&A.

Jeff Hammond, KeyBanc Capital Markets.

Good color on kind of initial thoughts on 2012 on cost savings.

You made the comment, you know, what you've announced thus far.

Are you contemplating additional actions that would get announced and maybe just a comment on price costs as we've seen commodities dip down here?

Well, let me first talk about commodities, then I'll talk about the cost side of the equation.

You know, as you suggested in your comments, we've seen commodity prices have eased some from earlier this year but been moving around quite a bit.

And as you know we systematically hedge copper and aluminum such at 12 months out we're around 50% hedge.

Effectively, this creates a 6-month or so lag between spot prices and when we start to see the impact on our P&L.

Right now our hedge position on aluminum copper are about 10% to 20% higher than a year ago.

Where we stand now with what we all ready have hedged is 10% to 20% higher than where we stood in 2010 going into 2011.

Steel is the other major commodity and while prices are down some, there's still is uncertainty.

For us steel is priced on a one quarter lag, the CRU spot price with a discount applied off that.

So there's lots of movement on uncertainty around commodities even now for next year.

Regarding price, over the years we've been good about capturing price against commodity headwinds, and as our standard practice we'll update you with specific comments in December at the analyst day.

In terms of what we've done on the cost side of the equation.

We've reduced headcount at corporate and in the business units, we've moved some air handler production from our Marshalltown, Iowa facility to a lower labor cost facility in South Carolina.

South Carolina all ready had sheet metal capacity so it made most sense to get it there quickly for the savings.

Directly answering your question, we continue to queue up more projects as we see markets develop ahead of the 2012 selling season.

So we continue to build scenarios and will adjust our cost structure as needed.

Okay, but seems like if you were kind of net headwind this year of $15 million on price cost that you would at least catch that up into 2012, just based on additional price actions and then stabilization and commodities?

Short answer, is if commodities stayed where we're at today, that's a true statement.

Okay, okay great.

And then can you just comment on Kysor/Warren, it seems like if you pull that out, the profitability is still pretty anemic there.

Is that meeting expectations, you know, I think you had given some guidance into 2012 on accretion, how is that lining up versus plans?

We're executing against our synergy plan and feel very good about the acquisition.

We expect solid margin improvement as we exit this year and still expect $0.12 of accretion in 2012.

Okay, great.

Maybe a couple of finer point questions.

Where do you think inventories are at from your prospective in your system?

And if you can give us an ending share count for the quarter?

I'll let Bob give you the ending share count and make sure he has the --.

Do you know the ending share count?

I'll answer the first one.

This is for the rest on the call, Jeff, because you know this.

We're 80% one step where we sell directly to dealers, and then 20% we sell through independent distribution.

With independent distribution, I think, for the 20% we sell our Allied brands, it's pretty lean.

I think independent distributors have been cautious given all of the macroeconomic uncertainty.

On our one step, we have minimal inventory with dealers.

We think we've stocked the shelves, we just need some cold weather to set in to help drive furnace sales, but when the weather changes and the market picks up, the inventory will flow very quickly through our channel.

And Jeff, we closed out third quarter at about 51.6 million shares end of period, and as I mentioned in the script, full year, fully diluted will be at 53.5.

Thanks, guys.

Thank you.

We'll go to the line of Josh Pokrzywinski with MKM Partners.

Please go ahead.

Hi, good morning, guys.

Hi, Josh.

Hey, Josh.

Just looking for an update, in last quarter you gave some helpful commentary on the incoming order rates, not the number specifically, but the body language on commercial orders and where backlog was.

If we could get an update, that would be helpful.

Commercial and refrigeration had a strong Q3 as you saw in the numbers, but we've seen a bit of a slow down in orders as you would expect in the can macroeconomic environment and uncertainty.

Europe and mainly in the US, Europe has been resilient and while we continue to watch for any softening, we haven't seen it yet.

The slower orders in commercial and refrigeration are in part why we lowered our revenue guidance range for the year.

Got you.

If we could shift over to furnace expectations, I know the new product line or I guess the fuller line this year, was kind of a source of early optimism heading into the fourth quarter.

I would imagine you've seen some dealer loading there at this point.

Any kind of first update or first view on how that has trended versus early expectations, or is it just too soon to tell?

I think it's what you said, it's too early to tell.

I mean only in the last week or so as weather started to turn cold in many parts of the country, as the weather continues to turn colder we'll have a better read of the furnace sell through.

Because you are right, dealers have bought it and I think our dealers are excited by it, but we'll have to see how it sells through to really get a read on what it means for Q4.

Okay, and then just one final one on R-22.

Obviously, one of your competitors similarly sized competitors was out of that market this year and is looking to get back in next year.

Any way to calibrate how far above any kind of normal share levels you've been on the low end, I guess the 13 SEER product that might be at-risk next year should share normalize with another competitor stepping in?

I don't think we would be the one who would lose share as Trane gets more aggressive on R-22.

My guess is there's others on the entry level who've had more of a share gain at that position than we have.

And our R-22 play has been more with our Allied brands than with our Lennox brands.

And so I think that's a segment of the market we'll continue to compete in and do well.

All right, understood.

Thanks, guys.

Next to the line of [Robert Barry] with UBS.

Please go ahead.

Good morning.

Hey, Robert.

Good morning, Robert.

Did you mention that price was a benefit of 1% in (technical difficulty)?

Just check our notes and make sure what we said.

Short answer is, yes, that's what we said.

(technical difficulty) first couple of quarters it had been tracking higher than that, so I was curious what happened there.

I think it was the timing of the price increases in terms of when we announced them, and what we're seeing it and how it's flown through the P&L.

(technical difficulty) how the pricing piece would be less impactful?

No.

I don't think I have any color to show.

We didn't see, you know, the pressure on pricing really hasn't changed quarter to quarter, and it's just sort the timing of when we sell to builders, when we sell to contractors, the size of the dealer that we're selling to.

So net net I think we're comfortable where pricing was for the quarter.

Okay.

On commercial it looks like you had a pretty significant price mix benefit, I think you said about 7%.

Could you just explain what is providing that tailwind?

It all sounds like the increase that you announced (technical difficulty) have to continue to ramp (technical difficulty) quarter, is that fair?

You're breaking up on me, Robert, so I'll attempt to answer the question and maybe get on another phone and call back.

I think the question was why are we seeing such good price mix in commercial.

And I think it reflects a couple of things.

It reflects the success that we're seeing in our premium products, Energence and stratagost.

It also has to do with the mix of national accounts that we have in any given quarter, and it reflects the pricing actions that we've taken earlier in the year, so where in resi we had price increases at the end of last year and our commercial business we had some pretty significant price increases part way through first quarter.

And we at the time said in first quarter and second quarter that we'd start to see that price flow through second half of the year, and we're in fact seeing that.

We'll go to the line of Adam Samuelson with Goldman Sachs.

Please go ahead.

Yes, good morning.

I wanted to ask on Kysor/Warren, the acquired revenues was a little bit higher than we had modeled.

What was the underlining organic growth in that business in the quarter?

I think you've seen Hassmann struggle as they've worked through the divesture there and just wondering how you look at share on the refrigeration side?

Yes, Adam, I don't have the third quarter numbers for last year.

That was back when Manitowoc owned it.

Clearly we're seeing some good acceptance from their new product line and we continue to see future potential growth as they expand that into their full product spectrum.

Okay.

And then in the commercial business, I think you talked about slowing in US orders.

I know it's early for 2012, but you've seen some larger customers including Wal-Mart say their US CapEx is going to be down next year.

How do you think about the environment for 2012, even -- at least the high level?

I think it's what I said earlier.

There's lots of moving pieces both in res and commercial, and we'll give guidance in December of what we're seeing.

I think we're doing the right things in terms of taking cost out for any scenario, we think we have the right product, we're winning accounts, we think we're winning in the market place in commercial and refrigeration.

You know, as you well know the selling season -- or excuse me, the Christmas selling season has a huge impact open on our retail customers.

And so I think there's still some variables still to be played out for us to really have a clear view on 2012 markets.

Okay, that's fair.

And then just finally for me, the cut for CapEx for the year, what was the driver and so far maybe that was some of the longer term programs that you've been investing in, kind of maybe where was that cut coming from?

I think it's more just the timing of implementation.

It wasn't an explicit cut to generate cash.

It was just the timing of implementation of projects.

Okay.

All right.

Thanks very much.

Thank you.

We'll go to the line of Rich Kwas with Wells Fargo Securities.

Go ahead.

Good morning.

Hi, Rich.

How are you?

Todd, as we think about 2012 just from a mix standpoint just on the resi side, R-2 at 20% this quarter flat with Q2, do you think that's the high water mark or given the competitive landscape right now, do you think that mix goes up meaningfully from here?

I would expect year-over-year comparison on the mix side to be less difficult in 2012 than what we saw in 2011.

We're approaching R-22 is that it's going to be here for some time and we're taking actions to compete there.

As you said, it was about 20% of our revenue.

Again, it's early.

I think it's probably going to be greater next year than it was this year, but not the step up that we saw from 2010 to 2011.

I'm not sure what the high water mark, but it will be cresting soon, if I had to bet now.

Any sense that if the economy gets better that that kind of halts that growth or do you think that's the -- what's the biggest trigger in terms of the mix on that front in your view?

I think the biggest trigger medium term it will be as you suggest, the economy.

It's hard to imagine that in 2012 there will be enough meaningful movement in the economy to change the dynamic we've seen.

But I think it's the economy changing.

I think it's the closer we get to the efficiency changes in units which is 2014, that will help alleviate the R-22 move also.

Okay.

And then on the commodity front, I think last quarter you talked about some price increases from overseas suppliers affecting your increase in the commodity headwind from last quarter.

Where are you with that?

Is that fully implemented?

And do you expect to see any more headwinds on that front as you move out over the next few quarters?

For 2012 you know -- excuse me, for 2011 we sort of reiterated the guidance we gave in terms of the headwinds of commodities of $60 million to $65 million, and then pricing of $50 million and then material cost reduction of $25 million.

And then, the only guidance we've given on 2012 so far is what I said in the script that we're really --- we're gaining confidence in the engineering led cost reduction programs and we're confident that in 2012 we can get similar order of magnitude material cost reduction savings that we have had over the last few years.

But again I'll state the obvious.

If commodity costs stay where they're at or continue to go down, that gives us obviously leverage over our supply base and we'll take advantage of.

Okay.

All right.

Thank you.

We'll go to the line of Keith Hughes with SunTrust.

Please, go ahead.

Thank you.

Can you give us some sort of feel on the margin difference between an R-22 these -- the dry ship units and a traditional 13 SEER with 410A versus the higher?

Just any kind numbers will be helpful.

The margin percentage isn't so much different on a 13 SEER R-22 and a 13 SEER 410A.

I think the big difference is the dollar value is lower.

And then when you sell a 410A, you often bring the air coil and the furnace with it.

So I think it's both an unbundling of the system sell as well as the way the pricing of the R-22 unit has been positioned in the market by the low-end competitors.

It's sold at a $1 discount versus a 410A.

So are you getting substantially less margin just selling the R-22 unit versus the furnace and the other components?

If I understood the question, it's we miss out on -- we sell our R-22 units it sells for about --.

About $1800.

About $1,500, $1,800, where if we sell a 410A system, it's $5,000 or $6,000 when we put the whole system in.

Condensing unit to condensing unit, R-22's lower priced than what the 410A is.

Because your revenue numbers in residential are not all that bad, but I would expect them and the math you just gave me to be much worse, but it's the margin where you're getting hit.

That's where I'm confused.

Yes, it's the margin where we're getting hit.

So why are you getting hit so much more on the margin?

It seems like we would see more of a hit on the revenue line?

The reason we're getting hit on the margin is our furnaces -- this is a thought I guess I should have connected.

We on a year-over-year basis are down significantly in margin mix because a year ago it was not only -- did we not have R-22, but we had the $1500 tax credit.

And so it's a combination of the two.

So a year ago we were able to replace the 410A system, use the $1500 tax credit to sell up to our most premium furnace, and in essence say you can get a furnace -- premium furnace for half price.

This year we're not getting the tag-along furnace and we're certainly not getting as many premium furnaces.

It's a mix down on our furnace lines as well as a margin down on our R-22 condensing units.

Okay.

So going into 2012, barring any changes to the economy, and things of that nature, the mix as you read off between a 14 SEER and above and dry ship, those are basically going to stay about the same, they may move a few points in either direction, but there's nothing else out there that's going to cause that to move down; correct?

I don't think there's the structural changes that we saw from 2010 to 2011, at least not what we can see now.

The $1,500 tax credit R-22, I think the changes will sort of be the incremental changes.

There's a $500 tax credit that goes away next year, we don't think that will have the same impact as the $1500 -- going from $1500 to $500.

There's the point that was made earlier that the fact that even more -- at least one large competitor who didn't play this year in R-22 will sort of focus on it.

But I don't think there's the big structural changes or systematic shocks that we saw this year.

Okay, thank you.

Thank you.

(Operator Instructions).

We'll go to the line of Steve Tusa with JPMorgan.

Please go ahead.

Hi, good morning.

Hi, Steve.

Just to follow on to the question about that competitor.

I'm just curious as to the mechanics of how one kind of, you know, re-enters or gets into the R-22 market.

You know, from your prospective, how easy is it to kind of flip the switch?

Is it a function of, you know, educating and putting the right in place -- incentives in place for the dealers?

How hard is that to do because I presume you guys earlier in the year weren't plan on being a big player in R-22, but you've clearly taken -- or at least stemmed some of the share that your like competitor did?

I'm just curious as to strategically how easy that is?

I don't want to play Trane's hand for them, but I think the way we thought about it is -- well better stated, I think you have to have the right channel to sell it or it helps to have the right channel to sell it.

So premium dealers, high-end dealers aren't trained or aren't sort of skewed that direction.

You've spent years, decades training them system sell, premium sell, that's how we've really levered our Allied distribution network to do it.

Like I said earlier, we're 20% overall, but in Allied it's a much higher percentage, so we levered the distribution channel that's focused on entry level product.

I don't know how much of that Trane has and whether they're going to be able to make the switch.

But, you know, my guess is they'll find a way to sell R-22 into the market.

Right.

So your Allied brand, how much was Allied up in the quarter?

Allied was up -- well, what we talked about was up double digits in condensing units and down low-single digits overall in furnaces, and that was both brands together.

What does this, you know, R-22 result this year kind of tell you guys about the value proposition that the industry continues to try and push towards higher SEER products?

I assume that the --- you know you've got a good feed through service experts, so you must have a good read into the consumer behavior around compressor repairs in R-22.

How worried are you guys about the dynamic that this is just forever kind of a value industry and there may be some structural headwind even on the pent up side as you push SEER's and equipment prices higher, system prices higher?

I don't think it's changed forever.

Forever is a long time.

For 30 years this has been an industry where we've had multiple tiers and you've been able to differentiate around consumer requirements, whether it's historically been efficiency where it's increasingly becoming controls, and the quality of comfort that's produced.

I don't think that's changed.

There's lots of businesses where you continue to differentiate.

I think what it's taught us, I think it's taught a lot of people that when you're in the third or fourth year of a stark economic turn down and consumer i as fragile as they are now, they'll look to avoid spending money.

But we're still able to differentiate on the premium side.

We're still able to get money from premium product, and as the economy starts to heal, I think that we'll even see more of that happening.

I don't think the business is broken, I think it's shifted down given the economic environment, but it's incumbent upon us to innovate and differentiate so consumers want to spend the incremental money because it will either save their operating costs or allow them to have a cooling experience like they'd like.

And we think we can get paid for that.

Right and clearly stuff is still breaking, obviously, so it's not as if there's not this, you know, pool of aging units out there it seems like given that R-22 has jumped so much this year.

Correct, no, there's still pent up demand being created and there's still a bio-wave coming and when that bio-wave comes we think we're going to be in a position because the economy would have turned, that we're going to mix up like we always have.

And not just us, like the industry has.

Right and the need to calibrate expectations for the fourth quarter.

You know, it was a good quarter with the end of the tax credit for some.

What -- anything you want to just let us know about how you see the fourth quarter right now, incremental weakness anywhere or any dynamics around the fourth quarter?

It's really too early to tell just honest answer.

We lowered our revenue guidance for the full year, that reflects, as I said earlier, some of the weakening order rates we saw in commercial and refrigeration.

On the resi side, we have to have the weather turn cold and see the sell through.

We've done a good job positioning at independent distributors and at our dealers, and we just have to see how weather shakes out.

But again as we all know, our resi business is a 2-week lead time and up to 40% of the volumes in the month of December.

So we still have a lot in front of us.

Sure.

Okay.

Thanks a lot.

Thank you.

And I'll turn it back to Todd.

Thanks, everyone.

I want to leave you with a couple of key points.

Our commercial and refrigeration businesses have been solid with good shipment growth and favorable price and mix.

Residential has seen good shipment growth and favorable price, but mix continues to be down compared to a year ago.

In response, the Company has taken aggressive cost reduction measures and continues to engage in new productivity and growth initiatives for 2011 and 2012.

The final point is that we will continue to use our strong balance sheet to grow the business, as well as return cash to shareholders through a competitive dividend and share purchases, including a target of $120 million in 2011.

Thank you for joining us today.

Thank you.

Ladies and gentleman, that does conclude your conference for today.

Thank you for your participation and for using AT&T Executive Teleconference.

You may now disconnect.