Lennox International Inc (LII) 2016 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Lennox International second-quarter 2016 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 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 Lennox International's financial performance for the second quarter of 2016.

I'm here today with Chairman and CEO, Todd Bluedorn, and CFO, Joe Reitmeier.

Todd will review key points for the quarter and Joe will take you through the Company's financial performance and outlook.

To give everyone time to ask questions during the Q&A, please limit yourself to a couple of questions or follow-ups, and re-queue for any additional questions.

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

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

We'll archive the webcast on that site for replay.

I would 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.

The Company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events (technical difficulty).

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

Thanks, Steve.

Good morning, everyone, and thanks for joining us.

Lennox International realized strong margin expansion and profit growth across all three of our businesses in the second quarter.

This set new record highs for the Company.

On a GAAP basis, operating income rose 23% to a record $161 million, and operating margin expanded 260 basis points to a record 15.8%.

Total segment profit rose 20% to a record $161 million, as total segment margin expanded 230 basis points to a record 15.8% in the second quarter.

Revenue was up 3%, negatively impacted by the cooler start to the summer in which April and May cooling degree days were down nearly 20% from last year.

Weather turned warmer in June, and has remained warmer so far in July, for a good start to the third quarter.

GAAP EPS from continuing operations was up 41% in the second quarter to a record $2.52.

Adjusted EPS from continuing operations was up 38% in the quarter to a record $2.53.

In our Residential business in the second quarter, we set new records for sales, margin and profit.

Segment profit was up 16% on 4% revenue growth.

Segment margin rose 220 basis points to a record 20.2%.

On the operations front, we continue to see a smooth regulatory transition from 13 to 14 SEER minimum efficiency in the South and Southwest regions of the United States.

And 14 SEER pricing has been in line with what we expected in our financial guidance.

The regulatory transition was complete at the end of June, since no more 13 SEER air-conditioners can be sold or installed in the South and Southwest.

Our overall residential mix was impacted by channel mix, as Residential New Construction and National Account business grew faster than Replacement business.

Residential new construction revenue was up low double digits again this quarter, compared to a mid-single-digit growth in the Replacement business.

Regarding distribution expansion, we opened five new Lennox PartsPlus stores in the second quarter to total 193 stores.

We are on track to open 27 new stores and end the year at 213 stores.

These stores have been enabling us to win new dealer contractors to Lennox and gain market share, as well as provide a high level of equipment parts availability to new and existing dealers in the market.

Turning to our Commercial business, revenue was flat compared to the strong prior-year quarter, in which we were up 10% at constant currency.

Commercial margin and profit set record highs.

Segment profit rose 10%, as Commercial margin expanded 170 basis points to 18.7%.

In North America, Commercial equipment revenue was flat at constant currency.

Non-National Account revenue was up low-single-digits, and National Account revenue was down low-single-digits.

We continue to see strong winds for new National Account customers, with 10 more wins in the second quarter, to bring the total to 20 already this year.

On the service side, National Account service revenue was up low-single-digits.

In Europe, commercial HVAC equipment revenue was relatively flat.

In Refrigeration, revenue was up 6% at constant currency in the second quarter.

From a regional perspective at constant currency, North America was up mid-single-digits, Australia was up low-single-digits, Europe was up mid-teens, South America was down high-single-digits, and Asia was up more than 30%.

Refrigeration profit rose 60% from the prior-year quarter, as segment margin expanded 390 basis points to 11.1%.

For the year in Refrigeration, we now expect segment margin to be up about 200 basis points versus our previous guidance to be up 100 basis points.

Overall for 2016, our underlying market expectations by the year remained consistent, despite some headwind at times from weather in the first half.

We are reiterating revenue growth guidance on a reported basis with foreign exchange now expected to be neutral, and are raising guidance for EPS from continuing operations.

We have recently raised the dividend, completed our previous $200 million stock share repurchase program, and today announced a new $100 million stock repurchase program for the second-half of the year.

We are excited about the second half, and continue to expect another record year with strong margin expansion and profit growth.

Now I will turn it over to Joe.

Thank you Todd.

Good Morning everyone, I will provide some additional comments and financial details on the business segments for the quarter and full year starting with Residential Heating and Cooling.

In the second quarter revenue from Residential Heating and Cooling was a record $575 million which was up 4%.

Volumes up 3% and Price and mix combined was up 1% on revenue basis.

Foreign Exchange was neutral to revenue.

Residential segment profit was record $116 million that was up 16 percent from the prior-year quarter.

Segment profit margin was a record 20.2%, up 220 basis points.

Segment profit was impacted by higher volume and lower material costs, with partial offsets from unfavorable foreign exchange and investments in SG&A and distribution expansion.

Now turning to our Commercial Heating & Cooling business, Commercial revenue was $253 million in the second quarter.

That was flat compared to the second quarter a year ago.

Volume was down 1%, and price and mix combined was up 1%, and foreign exchange was neutral to revenue.

North American Commercial HVAC equipment and service revenue was flat, while Europe Commercial HVAC revenue was also flat.

Commercial segment profit was a record $47 million, which was up 10% from the prior-year quarter.

Segment profit margin was a record 18.7%, and that was up 170 basis points.

Segment profit was impacted by lower material costs and favorable price mix, with partial offsets from lower volume, unfavorable foreign exchange, and investments to support growth in the Commercial Services business.

In our Refrigeration segment, revenue in the second quarter was $192 million, and that was up 4%.

Volume was up 7%, and price and mix combined was down 1%.

Foreign exchange had a negative 2% impact on revenue.

From a regional perspective, Todd addressed revenue growth in constant currency.

On a reported basis, North America was up mid-single digits, Australia was down low-single-digits, Europe was up mid-teens, South America was down more than 20%, and Asia was up nearly 30%.

Segment profit was $21 million, which was up 60% from the prior-year quarter.

Segment profit margin was 11.1%, and that was up 390 basis points.

Segment profit was impacted by higher volume, lower material costs, and lower factory costs and higher productivity.

Commercial offsets included unfavorable price mix and foreign exchange.

Regarding special items in the second quarter, the Company had net after-tax charges of $300,000.

This amount included $1.4 million for restructuring and other items net, and a $1.1 million special legal contingency gain.

Corporate expenses were $24 million in the second quarter compared to $22 million in the prior-year quarter.

Overall, SG&A was $159 million in the second quarter compared to $153 million in the prior-year quarter.

Net cash from operations in the second quarter was $72 million compared to $70 million in the second quarter a year ago.

Capital spending was $18 million, up from $15 million in the prior-year quarter.

And free cash flow was $54 million in the second quarter compared to $55 million in the prior-year quarter.

We ended the second quarter with a total debt of approximately $1.1 billion and had a debt-to-EBITDA ratio of 2.2.

We paid $16 million in dividends in the second quarter, and at the end of June, cash and cash equivalents were $55 million.

Now to review our outlook for 2016.

While the first half of the year has seen some headwind from weather at times in our markets, looking at what we expect for the full year, our underlying market assumption ranges remain unchanged.

For the overall industry, we expect North American Residential HVAC shipments to be up mid-single-digits; we expect North American Commercial unitary shipments to be up low-single-digits; and we expect North American Refrigeration shipments to be up low-single-digits.

We continue to expect revenue growth of 3% to 7% for LII overall this year, and we now expect foreign exchange to have a neutral impact versus our prior expectation for a negative 1 point impact.

At constant currency for 2016, revenue growth guidance is now 3% to 7% compared to prior guidance of 4% to 8%.

We are raising our guidance for GAAP EPS from continuing operations for the full year from a range of $6.26 to $6.76, to a new range of $6.45 to $6.85.

We are raising guidance from adjusted EPS from continuing operations for the full-year from a range of $6.30 to $6.80, to a new range of $6.50 to $6.90, excluding $0.05 of special items in the first half.

The higher EPS range reflects the Company's strong operational performance and outlook, as well as a lower effective tax rate.

As I mentioned last quarter, we have structurally reorganized our international subsidiaries for our businesses today.

As a result, we are able to utilize foreign tax credits and other benefits that drive our effective tax rate down.

Much of the benefit from the foreign tax credits come in the second quarter, and these were a benefit on top of the operational outperformance in the quarter.

For the full year, we now expect a lower effective tax rate of 31% versus prior guidance of 32%.

To give you more color, we expect our third-quarter tax rate to be approximately 32% and our fourth-quarter tax rate to be approximately 34%, to get to the 31% rate on a full-year basis.

Looking beyond 2016 to future years, we expect approximately a 32% effective tax rate.

An additional benefit of the tax reorganization is our ability to repatriate cash generated in prior periods in a tax-efficient manner.

We plan to repatriate $50 million in cash from our foreign subsidiaries, and contribute the $50 million to our pension plans in 2016.

The $50 million in cash was generated in prior periods that we now intend to use in 2016.

As a result, we are adjusting our free cash flow target to reflect our use of the cash this year.

Our free cash flow target will now be $200 million for 2016 versus the $250 million previously provided.

Let me now walk you through other drivers of our guidance and the puts and takes for 2016.

Starting with the guidance points that are changing beyond those already discussed, foreign exchange is now expected to be a $10 million headwind for the year versus the prior guidance of a $20 million headwind.

We now expect a $40 million benefit from sourcing- and engineering-led cost reduction actions compared to prior guidance of $35 million.

And we now expect a $45 million benefit from commodities and price combined compared to $40 million benefit in the previous guidance.

Within this total, we are raising the commodity savings from $25 million to $35 million, and fine-tuning the price benefit from $15 million to $10 million.

We are also fine-tuning the guidance for Residential mix from a $5 million benefit to relatively flat in 2016, driven by channel mix.

We have seen double-digit growth in New Construction so far this year compared to mid-single-digit growth in Replacement business.

For corporate expenses.

we now expect $90 million for the year compared to prior guidance of $85 million as we continue to invest in the businesses for growth.

A few guidance points that have not changed -- we still expect $11 million of incremental savings this year from our second plant in Mexico.

We still assume net interest expense of approximately $29 million for the year.

The weighted-average diluted share count guidance for the full year remains approximately 44 million shares.

And finally, we continue to target capital expenditures at approximately $95 million for the full year.

And with that, let's go to Q&A.

(Operator Instructions) Jeff Hammond, KeyBanc Capital.

So just on the raw material, it looks like you are bumping up the commodity savings.

Just speak to that.

What is driving that?

I mean, we are seeing kind of some inflation on steel.

And maybe how should we think about that into the second half?

Yes.

Good question, obviously.

In our prior guidance, we had assumed that the spot price of copper and aluminum would go up during second half of the year and impact the part of our positions that remained unhedged.

That has not been the case so far.

And so, it's good news on the copper and aluminum side.

Steel pricing, we have locked down between now and the end of year.

Thinking about 2017, if spot prices were to remain flat at this point, steel would be a pretty significant headwind for us next year, offset by copper -- or partially offset by copper and aluminum.

But we will have to see how commodity prices continue to develop in the second half.

But if steel is up year-over-year next year, which it looks like it will be, then we will go out into the market and raise price to offset it, just like we have in the past.

Okay, great.

And then on the commercial business, certainly a good first quarter and then a flatter second quarter.

Is that -- do you think of that as lumpiness?

Was your emergency replacement impacted by weather?

Just -- what are you seeing from a trend standpoint there?

I think it's predominantly lumpiness.

So, what we talked about in the call or on the script was, our non-National account business, which is sort of all the other verticals besides national accounts, was up low-single-digits.

Parenthetically, I would tell you emergency replacement, which is a subset of that, was up mid-single-digits after being up double-digits in first quarter.

Weather had some impact on emergency replacement, and I think why we were only up single-digits rather than high or double-digits.

And then our National Account business was down low-single-digits in the quarter.

It's no news that Walmart is going to be down this year for many of its suppliers in the HVAC or refrigeration business.

Walmart aside, our backlog in National Accounts is up high-single-digits as we go in the third quarter.

So we feel good about National Account business in the second half of the year.

Okay.

Great.

Thanks, Todd.

Thanks.

Tim Wojs, Baird.

Just on the cadence in the quarter, just had -- I mean, I know weather in April and maybe May was a little bit of a headwind.

Did it really warm up enough in June?

And I guess how would you to find the trajectory in July here?

Yes, I mean, April and May were cooler, as we talked about.

And everybody can read the weather maps.

It was cooler, about 20% cooler than last year from degree cooling days.

June warmed up nicely.

I would tell you parenthetically, even in our business where we sell direct to dealers, when you have warm weather the last 7 to 10 days of the quarter, that really sort of carries you into the next quarter.

Because even dealers have -- they are booked out on jobs, they are buying the equipment a little later than when you see the weather.

We used the word in the script of strong start to Q3.

And I would underline that for Residential.

We had some weather headwinds in fourth quarter.

We had some weather headwinds in first quarter.

We had a little bit of weather headwind in second quarter, but we're coming out of the gate strong in Residential for third quarter.

Okay.

And then you have talked in the past about higher efficiency cooling shipments.

I think the SEER transition kind of through a little bit of a wrench in that metric.

Is there any way to try to gauge what is more minimum efficiency versus maybe 16 SEER and above?

Yes.

You know, we need to come out with a little better metric than what we have now.

I mean, what I would give you now is almost unusable, which is second quarter last year compared to second quarter of this year, our 14 SEER and above is up 17 points.

But to your point, that reflects a regulatory change.

We're going to recalibrate this.

We want to get through the summer selling season, so let us get through third quarter, which is part of the summer selling season.

And then when we get together for December Analyst Day, we'll have some new metrics and sort of recalibrate people going forward on how to think about mix-up.

Okay.

And then last one -- the $100 million -- the new $100 million share repurchase -- that's not in guidance for the second half of the year?

I'm not sure I understand the question, so let me restate it.

The $100 million share buyback is contained in the guidance that we gave today.

It is contained?

Okay, great.

Thank you, guys.

Thanks.

Steve Tusa, JPMorgan.

Just a quick question on the -- going back to kind of the raw materials dynamics, so, is there any way to kind of frame this?

I mean, you know you've had -- you are now going to have, I guess, $35 million in commodity benefits this year.

And you used the term substantial.

If we kind of just snapped the line on where these things are today, do you reverse that entire $35 million?

I mean, my guess is the term substantial -- you kind of put some emphasis on that.

Is that at least kind of a good starting point?

I'll answer the question directly.

Let me ramble, so I can spin it my way, in the spirit of what's happening in Cleveland this week.

(laughter) But for 2016, if you listen to the detailed guidance we gave, we are saying it's a $45 million benefit from commodities and price.

So $35 million from commodities and $10 million from price, and we are flat on resi mix.

So those three items are positive $45 million.

When we think about 2017, if steel stays where it's at, we're going to have a headwind of commodities rather than a tailwind.

So yes, the $35 million goes away.

But I'd parenthetically tell you that the price would be significantly higher than $10 million and we would also have positive mix.

So I think the bigger question to think about isn't are we going to have $35 billion of commodities?

-- because the way we are sitting now, we won't.

It's what's that $45 million of commodities price and mix?

And I think if you go back and check, even in years where we have commodity headwinds, we are able to get significant price to help offset it and a positive mix to help offset it.

Right.

But I guess you are tempering your price for this year a bit from $15 million to $10 million.

I mean, that --

Yes.

Does that kind of give you a bit of a pause as far as the degree of -- I mean, our checks suggest that pricing power remains pretty good for most suppliers out there.

So is that just a kind of a -- why (technical difficulty) today than yesterday?

Well, I -- because I don't think the costs of the commodity shock of steel has rolled through the P&L yet.

I have a different perspective than you do.

I think that $45 million from commodity and price in the same year is strong performance.

And so, even with commodities rolling through low, we have been able to get pricing.

At the same time, the Canadian FX has moved in a positive direction to us, and that was one of the drivers of price that we needed for this year.

But I mean, it's good news through the P&L.

So I'm more optimistic about both the results and the future that we are going to be able -- while commodities are going to be a headwind, we're going to be able to offset it.

And I guess, just as the math, if we wanted to do our own back of the envelope, should we just take -- I guess you have ceilings on steel for the year.

I guess that's kind of the way -- we just take the year-end steel price as of last year, just to see where it is today, and that's kind of the degree of snap-back?

I mean, can we use that analysis at least as a starting point?

(multiple speakers) Or is there some sort of catch-up or something like that?

I don't know if I'm asking the question the right way.

No, you are asking the question the right way.

Is that the mechanism?

Is that the way it works?

I think there will be -- the way I would think about it is, there's going to be a little bit of a lag because we will have some of the steel that we buy in fourth-quarter bleed into 2017, number one.

Number two is it's tough -- it will give you an artificially high number if you take the starting price in 2016 and compare it to the starting price in 2017 in the spot market.

Because, with the agreements we had, it wasn't tied to what the lowest price was to start the year.

We had some collar on it but not at that level.

So I understand what you want to do.

And you can start to ballpark it.

But we will give clearer guidance in December when we see where steel shakes out, as well as the other commodities.

Right.

But just to be clear, there is a risk that it will be a negative -- it will be negative?

I mean, you're not necessarily saying that today, but it will be negative?

Yes.

I mean, I think when I use headwind, that's my way of saying it's going to be negative.

I think we're --

Okay.

Because then you said the $35 million goes away.

So maybe I was just thinking less of a tailwind.

Okay, that's --

I think we are going to pay more for --

That's great.

-- because it's change to change.

Right?

Yes, sure.

Sure.

So, we are going to pay more for steel next year than we did this year.

Yes, 100%.

And then just one last one.

I mean, how good was June for you guys in resi?

We had a nice June.

We had a nice June.

But even to underline what I said, it's a nice June but it got us out of the blocks quickly for July.

And some of the weather in June helped us as we rolled into third quarter.

So double-digit?

Can we think double-digit for June?

(laughter) I'm not going to answer the question.

I understand the question.

Okay, thanks a lot.

Ryan Merkel, William Blair.

First question, on EBIT margin.

I think for 2016, you're tracking ahead of the 12.5% target that you set out.

Can you just provide an update on your thinking there?

We are a seasonal business, and it's sort of hard to track exactly where we should be -- for you guys to track exactly where we should be.

Commodities have been more front-end loaded, for some of the reasons we just talked about with Steve.

And so I think we had more benefit of commodities first half of the year.

But if you take the midpoint of our guidance, on guidance, we've lowered revenue slightly and we've raised earnings slightly.

So my guess is -- well, not my guess -- the math is the 12.5% is going to go up some.

Right, okay.

Then on SG&A, you haven't leveraged that the past few quarters.

Is this something we should expect in the second half of the year?

I think what it reflects is we are cognizant on the significant investments -- not significance, but the important investments that we need to make in IT and our ability to serve our customers.

And we don't outline those quite as dramatically as several of our -- or at least one of our competitors does.

But we are making the same kind of investments, and I think that's reflected in the SG&A.

But the direct answer to your question is, over the medium-term, which is over next couple of years, you should expect to continue to see leverage in SG&A.

Okay.

And just lastly, the change in the resi mix guide to flat, is that more a function of mix by channel versus the consumer appetite for higher SEER equipment?

Yes.

And it especially reflects the two things that you are talking about, selling to some National Accounts, which are important to what we do.

But the main driver is Residential New Construction growing quicker than Add-on Replacement.

And it's -- Add-on Replacement is still a healthy mid-single-digit growth rate; it's just Residential New Construction was up double-digits.

Got it.

Thanks, Todd.

Robert Barry, Susquehanna.

So I did want to just clarify more specifically what the growth rate was in the order for the add-on replacement component of resi.

Mid-single-digits.

Okay.

And I guess I also just -- so how much do you think weather cost you in the quarter in resi?

A point or two of revenue growth.

Okay.

I guess I'm just trying to square the comments you have historically made about weather being mostly relevant to June, in the second half of June, and it was hot in June, especially in the second half.

And some of these swing regions that matter, like the Northeast and the upper Midwest, were particularly warm.

Given mid-single and Add-on Replacement against what became a much easier comp in Add-on Replace suggests the cool start had a pretty significant impact.

I think what I'm -- the short answer is it had an impact, a significant impact.

And then I've said it a couple times, but I'll underline it -- the weather the last 10 days or so really is going to have a positive impact on third quarter rather than second quarter.

The demand was there, but what sort of happens when it gets that hot that quickly, that our dealers are busy.

So if you call to get your air conditioner replaced, instead of somebody saying I'll replace it today, they will say I will be out next week.

And then they delay the order and the shipment for us for a week or 10 days until they are ready to come out and do the job.

And that's what we saw at the end of second quarter.

And some -- the weather the last week or two really is helping us get off to a strong start in July.

Got you.

So as you see it, I mean, everything else -- share gain around the distribution enhancement, the pent-up demand, all of that, in your view is the same; it's really just weather?

Yes.

I don't -- the short answer is yes.

The long answer is we feel the sentiment of the consumer is still positive.

We talked to our dealers; they are still very happy.

They are extraordinarily busy right now, as they have been for the last six weeks or so.

And we've got a -- there's lots of moving signals because of timing of things last year.

But I think it's steady as she goes on Residential revenue.

And I think it was you who asked the question -- I mean, I think it was a point or two on resi revenue, and I think that helps answer the question.

And I think it's weather.

And our team is confident it's weather, and that's the issue.

And we are ready for a strong -- and are off to a strong start in Q3 in resi.

Got you.

Maybe just a quick one on commercial.

Todd, you made some very positive comments late in the quarter on the strength in the Commercial business, particularly in planned Replacement and even in Retail.

And then it came in flat.

I know you had a tough comp.

I don't know if you just want to perhaps add some additional color there?

Maybe you were referring more to the margin performance?

No.

I mean, I think what I was trying to underline -- I mean, I think when I talked publicly -- or even privately about the Commercial business in the second quarter in National Accounts, I always, I think, try to carve out Walmart.

And I always said people understand what's going on with Walmart, given some public comments by our competitors.

And we are seeing the same thing.

And what I mentioned in the script is that, Walmart aside, our backlog is up high-single-digits in National Accounts.

And our non-National Account business was up low-single-digits for the quarter.

Got you.

And where is the mix benefit coming from?

Because you said emergency was up more.

Is it the service business?

Service business was up -- was a big piece of it.

And even within our non-National Account business, we are seeing a mix up to higher efficiency equipment.

Got you.

Thank you.

Thanks.

Julian Mitchell, Credit Suisse.

Yes, I just wanted to switch to Refrigeration a second.

I mean, if you look at that business -- very, very good margin performance yet again.

I think it's sort of the fourth consecutive quarter where you've had a very good margin expansion year-on-year.

The comps, I guess, on margins start to get a little bit tougher in the second half.

On the other hand, maybe price mix stops being a headwind at some point.

So if you could just give some color on how you see Refrigeration margins kind of playing out from here?

Well, I guess I'll just underline something that you said, which is, by our records, fifth straight quarter of margin expansion in Refrigeration.

And the drivers are things that you would want them to be -- volume, lower material costs, improved factory productivity -- are all driving the margin expansion.

Though -- but I think the point you made is right; we saw a ramp-up in volume second half of the year last year with some of the Walmart business.

We are now going to lap that, and so the comps get a bit more challenging.

All that being said, though, we have said that we're going to -- or we expect Refrigeration margins to be up 200 basis points this year from our prior guidance of 100 basis points.

And I think with that endpoint, you can sort of back into margin second half of the year.

And the -- how about price mix impact?

We continue to look to mix-up in our business.

And part of the issue that drives mix in Refrigeration is across the different businesses.

And some of our -- one of our best businesses is our -- not our display case business in North America but our core Refrigeration business in North America.

And it's strong and has had strong growth rates through the year-to-date, and we expect that second half of the year.

And I think that will help the mix of the business.

Thanks.

And then back to Commercial, just around the non-National Account business, so I guess it sounds as if it is sort of purely lumpiness.

There was no particular slowdown in any kind of vertical or end market that you saw.

Maybe give any update on sort of specific end markets, how the order intake is moving?

You know -- and again, it's up low-single-digits on non-National Accounts.

I think the one vertical that we've seen some softness year-over-year -- and we had a really big year last year -- was in K through 12.

And so that has slowed down a little bit.

And I think that's the end market, not our share of it, for lots of different reasons.

But other verticals -- light industrial, small office building, your local dentist office -- all those verticals sort of remain -- they are not on fire, but up low-single-digits.

Great.

Thank you.

Thanks.

Rich Kwas, Wells Fargo.

So, Todd, on -- I know you don't give quarterly guidance, but just wanted to -- as we think about Q3 here, you are going against a pretty tough comp in resi --

Yes.

-- from a volume standpoint.

So, in the context of the comp you just went through in Commercial here this past quarter, it would seem obviously you should do better than what you did in Commercial this past quarter, in Residential here in Q3.

But is there any way to think about that?

Anything you would point out?

I agree there's a tough comp or tougher comp, but I've said five times we are off to a strong start in res.

I don't know how many more times I can stamp my foot.

Okay.

Just want to check.

Yes.

And then on -- as you look at next year with incrementals, so with the headwind on the commodity side, do we think of that -- how do we think about it as it relates to your normal 30% incremental margin?

And you have been trending well above that with some of the commodity savings.

And I know you have sourcing in there and whatnot.

But do we think of this kind of from a lumpiness standpoint, where it should -- could trend below that until pricing really sticks?

Or is there any thoughts on that as we think about looking out into next year?

Yes.

I mean, if I would model, I would take where we are going to end the year, take a look at the two -- the three-year target that we gave last year, and then you have two years you've got to sort of lay out.

And I would lay those out and assume, over the three-year period, maybe on a little less revenue, we'd still get to the raws location.

So, we are still going to have nice drop-through.

But look, I mean, we will underline it, everyone understands this -- we had a 100% drop-through this quarter.

That's not normal, and that's not something you do all the time.

That's what you do when you have a commodity tailwind and you are getting price, and you are doing Mexico and you are doing everything else we are doing.

That normalizes over time.

But I still -- 30% is still the incremental margin I would use for the out-years.

And then lastly for me on the -- with regards to further restructuring that could occur, there's more on the table potentially on the Residential side, correct?

I'd broaden the question and the answer to say we continue to look at ways to lower our cost structure both on the factory side and non-factory side and -- point one.

Point two is, I've said over and over again, we are not done in Mexico.

And we think that's a great facility.

And we have two factories there, and we continue to think through what's the right play to continue to leverage our volume in Mexico.

Okay.

And then last one -- $0.40 spread for the balance of the year -- that was narrowed a bit but not as much as you've done in the past.

Anything to think about there?

I'll say this and sound arrogant, and I don't quite mean to, but $0.40 on a $3 guide is different than $0.40 on a $6.70 guide.

So, while it's still $0.40, I think as a percentage, it's even tighter than it's been in the past.

Okay, thank you.

Jeff Sprague, Vertical Research.

Just a couple things to clean up, a lot of ground covered here.

Just on 14 SEER, Todd, as you said, it's kind of case closed.

But just wondering if it is totally case closed from an industry standpoint, from your vantage point?

In other words, do you see people stuck with inventory in the South that they are moving North?

Did you have any yourself?

Just the state of the channels, from your vantage point?

I really haven't seen any behavior by others, so I can't -- I won't directly respond to that.

Our guys may know, in the field; I don't know right now.

But we had a little bit and de minimis to our results, and we have already accounted for it and are in the process of moving it North.

And we always knew that we wanted to have the last bullet and the last shot fired in the war, so we didn't want to run out.

And so we made sure we had enough, and we had a little bit left.

And we moved -- are in the process of moving it.

Great.

And then I'm just wondering, pension, perhaps for Joe, by my math, just this move in interest rates created a $40 million -- $50 million headwind in your funded status.

So it looks like you are plugging that hole this year.

Would you see the need for further pension contributions into 2017 and 2018, if rates stay this low?

Well, good question, first of all.

Second of all, I want to go back and talk about the tax benefits that we derived.

It afforded us the opportunity to have access to about $50 million in cash that -- we looked at various places where we thought we could most effectively utilize that cash.

We looked at the pension plans.

To your point, the discount rate has moved down.

With this pension contribution, it enables us to once again raise our funding levels, with the expectation over time that discount rates will increase.

And when they do, it will continue to afford us the opportunity to further de-risk the pension plans.

I mean, the direct answer to your question, Jeff, is, we are not sure.

We have to see how asset returns come in as well as where the discount rate ends the year at.

But we thought that $50 million was a prudent use of cash that we got from the change in our tax policy.

Yes.

I'm just wondering if you -- I mean, it does make sense, obviously; I get it.

Are you flirting with getting snagged in mandatory requirements or anything?

Are you --

No.

-- basically the contribution keeps you in front of that?

No; this was purely voluntary.

And when you look at our strong cash flow supported by strong earnings, we're confident that this is an opportunity, like I said, that will afford us the opportunity to continue to de-risk the plans going forward.

And once again, this is a voluntary contribution that we are making to sort of get a little bit ahead of it, as you mentioned.

Terrific.

Thanks a lot, guys.

Thanks, Jeff.

Nigel Coe, Morgan Stanley.

Just a couple of quick cleanups here for me.

So you did a good job of managing inventories this quarter, Todd.

But one of your competitors did allude to the possibility of excess inventories entering June and therefore maybe some potential for weak entry pricing.

Did you see any of that from competitors?

No.

And I assume you are referring to UTX and, through extension, Watsco.

My guess is the warm weather helped their concerns.

Okay.

And then was the weather impact mainly within the Northeast?

Or was it broader?

And in particular, did you see any impact of shale in Texas?

What was the question about Texas?

Did we see any what?

I just was wondering if the oil CapEx declines are having an impact on consumer demand in Texas?

No.

I mean, the weather was wide.

I mean, where it was warmest was, I think, where we are historically stronger, which is in the Central part of the country, Central Northwest; and then also on the West Coast, especially California.

On the specific question of Texas, no.

We haven't seen any impact to our demand, even in places like Houston.

In the Woodlands, there's still lots of housing going in for ExxonMobil's move to the suburbs.

And so, even with -- at the low oil prices, we continue to do fine in Texas.

Okay.

And then just one more on the buyback.

Would you hope to get the $100 million done by year-end?

Yes.

Yes?

Okay, great.

Thanks, Todd.

Walter Liptak, Seaport Global.

I've just got a couple of cleanups, too.

You mentioned, with the commodities headwind that's coming, that you would be potentially raising prices for next year.

I wonder beyond that, what's your expectation that you would be able to neutralize the commodity cost headwind?

Or do you think you can get a benefit in 2017?

You know, we are going to have to see how it all shakes out.

I think I would look to the past as a predictor of the future.

And so in past years, when commodities are up moderately, we are able to offset it and then some with price and mix.

And steel is what's gone up parenthetically, without being political artificially because of tariff rulings and a tariff on imports.

The underlying economy internationally still remains in such a way that copper and aluminum, I think, are still going to be -- at least where they stand now, are going to be benefits to us next year.

So we have benefits for two of the commodities, headwind from one.

All combined, it's going to be a net headwind, where it stands now, and we are going to focus on getting price and mix to offset it and then some.

But we will have to see how the final math shakes out.

Okay, that sounds fair.

This commodity situation for next year seems to be very well--telegraphed by you guys, by the industry.

I think everybody knows it.

Any thoughts or any conversations with customers about pre-buying ahead of any price increase for next year?

No.

You mean our customers?

Yes.

No.

I mean, it when -- typically, given that we sell -- we own our own Company distribution and we are selling large parts to dealers, they just don't carry enough inventory to have a meaningful impact.

And on the Commercial side, emergency Replacement obviously not the case, but even on planned Replacement, they have schedules.

There might be a little bit of pull-forward at the end of the year with a significant price increase looming, if we announce it -- or when we announce something in fourth-quarter.

But I think it would be material to the results.

Okay, great.

All right, thank you.

Joshua Pokrzywinski, Buckingham Research.

I think we've covered a lot of ground here, so maybe just one or two follow-ups from me.

I guess, Todd, first, on the price/cost gap in resi, 2Q to 3Q, should we expect 2Q to have been kind of the widest gap there?

And how should we think about that sequentially?

Well, I think the drop-through in all three of the businesses was strong in second quarter as commodities, I think, were at their low point for us.

And so that's what I'd expect, quite frankly, for all three of the businesses.

As I said earlier, we're not going to have 100% drop-through going forward.

Okay.

So, I get it, and maybe a little less of a tailwind into 3Q.

And I guess back onto Refrigeration, clearly some internal initiatives have started to get traction there.

How much of the impact, if any, was from some of the stronger growth in Europe?

And how should we think about that?

As kind of new business?

Or anything that we can point to as having legs into 2017, as comps get tougher?

You know, our Refrigeration business was up in Europe and our team has done a good job there.

I think the driver of the revenue growth is North America, both in our display case business with the Walmart customer, but also in our non-display case business, we had a really nice quarter in North America.

And then the margin expansion is driven by a lot of self-help on material costs, commodities aside.

As I said earlier, the -- I guess, now the $40 million that we have assigned as a guide to material cost reduction, a higher percentage of that is in Refrigeration than it has ever been; and lower factory costs, as we have done significant improvement in productivity, both in our European business and our North America business.

So Todd, I know, just to maybe borrow your phrase, that you will understand this question.

But thinking about maybe a baseball analogy on Refrigeration margins, I guess any good CEO would say that you are still early innings and there's plenty of wood to chop still.

But do you feel like you have made it a significant way through some of the initiatives there?

How much left -- is left to go, just based on what you can see in kind of the pipeline ahead of you?

I think I'll give you some math.

We ended last year at about 7.5%, 7.4% -- someone just put in front of me.

We said 200 basis points up, so that would put us at 9.4%; but just for the hell of it, I would say 9.5% this year.

And we said our 2018 target was 11% to 13%.

So, I would say, sort of over our three-year journey to get to 11% to 13%, we took a nice chunk out of it in the first year, but we still have a ways to go to get to 11% to 13%.

And we have a roadmap to get there.

Got you.

A ratable roadmap from here or still front-end loaded?

I would lay it out ratable.

Perfect.

All right, thanks, guys.

If that means linear; I think it does.

(laughter)

Shannon O'Callaghan, UBS.

Hey, aside from the potential raws headwind in 2017, I mean, are you sort of glad to see this when you think 2018, 2019, et cetera?

I mean, was it getting tougher to get price with the declining raws?

I mean, is this something that has a positive side to it, in your view?

I mean, I know distribution talks that way because they are able to -- they view it as just sort of a higher cost of goods sold that they pass on.

I'd rather live in a world where our cost of goods sold was zero and all we did was sell stuff.

So, no; I mean, I don't think commodities going up is necessarily a good thing.

But the key is how do we handle it and how do we react to it.

And I've sort of said pretty aggressively that we have been through this before, we know how to do this, and we'll go out and get price.

And just as you think about the hedges and things like that, I mean, is there -- should we be -- is there going to be any quarterly lumpiness to this where we have to kind of think about backend-loaded year?

Just anything in terms of those dynamics we should be mindful of?

Again, it's -- we hedge on copper and aluminum.

And so I've said that's -- at least where we sit now, that's going to be a net benefit.

So you are going to have to lay out the hedge -- if you are going to try and guess before December, you're going to have to lay out those hedge positions over time.

And then on steel, we buy it based on a quarter's CRU.

But this year, we have been able to get some fixed pricing during the second half of the year, and so that's going to be hard to model.

So, I think the answer is there will be some lumpiness next year where the comps are tougher than at different parts of the year.

And I think it will be, broadly speaking, that the comps will be maybe most challenging first half of year and then get easier second half of the year.

And then just on Refrigeration margins, you talked about the five straight quarters, et cetera, and you have some nice momentum there.

I mean, are you ready to sort of, from an operational improvement standpoint, kind of declare a victory in terms of some of the challenges that you have had there?

Or they're kind of still visible things that are far from optimal?

Oh, let me answer it like I think you'd hope I would, which is, it's continuous improvement forever and amen.

So, we had 20% margins in Residential and we ain't done there on continuous improvement and making it better.

And so, we ended -- we're on target -- or we ended double-digits, 11% in Refrigeration, and we are not even close to being done with what we need to do there, albeit we have made some nice progress.

I think it's gone -- I think we have gone from critical care to the preventive wing of the hospital.

All right.

Great, thanks.

Robert McCarthy, Stifel.

I guess the question I have is, maybe just stepping back, talking a little bit about your investments in distribution, I think a comment, Todd, you made at our conference about just how you've changed your kind of view about distribution and the value it can bring.

And could you talk a little bit about the investments you are making there, and how you think that's going to be helping kind of your topline and bottom line?

Yes.

I sort of reflected there, and I've reflected publicly in the past, that each deck distribution 20 years ago -- distribution, not dealers but distributors, I would have said the model I thought made sense was local independent -- fragmented independent, because I viewed it very much as local business, where it's all about relationships and managing boxes of inventory and making sure things flowed locally.

But over time, that has significantly changed.

And I think it is increasingly changing.

And that's why we are making such significant investments in IT to support our dealer network through LennoxPROS, which is our online portal.

So being able to provide information, flow of material, being able to order, being like Amazon where you can track your delivery -- the dealer can track his delivery and know when it's going to reside; have an online portal where they can order, like you see in Amazon, where you buy the unit and the parts, and it reminds you if you are missing anything and what you need; to be able to have technician training online; to be able to have spare part availability when they arrive at the home.

And on our Dave Lennox Signature Series, where you have the iComfort to be able to do prognostics and diagnostics, so the dealer technician arrives at the home knowing exactly what's wrong before he gets there -- that's all value added that we can provide.

And I think, over time, as this value added becomes more and more a differentiator, those who have -- who own the distribution, or controlled national distribution, will have big advantages because they are going to be able to leverage that spend over a broader and broader sales volume.

And that's where we think we are at.

I'll leave it there.

Gautam Khanna, Cowen and Company.

Hey, I wanted to get your sense, Todd, of where you think we are in the resi replacement cycle?

If you can just calibrate us again, given the housing kind of boom of -- I guess it was now 10 to 12 years ago -- do you expect to see another bow wave, another increase in resi replacement as we move forward?

And if so, when would you expect it?

We are still very bullish on the resi replacement market.

And we've -- more broadly on the resi market, we think there is mid-single-digit growth for the next three to five years.

And I think there's three drivers.

One is the pent-up demand, we think, still exists.

So we think all that volume from, say, 2008 to 2011, 2012, where people were repairing rather than replacing, we still think those units are breaking for the second time, and we are seeing a bow wave of that pent-up demand.

Some of the sell-side analysts have painted as much as a full year of air conditioning volume was created over that four or five-year time period.

And we think, at the end of this summer, we will probably be two-thirds of the way through that, so there's still a chunk of that left.

Second is, simplistically stated, as your question implied, the new housing bubble becomes our replacement bubble.

So a unit lasts 15 -- 12 to 15 years or so.

So all those homes that were put in early in mid-2000's are now coming into the replacement cycle.

And then the third is -- and we have seen it for a couple years now, but we think it continues -- is, single-family starts, which is a driver of our New Construction business, we think, continues to grow, and never gets back to the peak -- at least I hope it doesn't, for lots of reasons, in my professional career, but still has a ways to go to get to the normal take-up rate.

And we are seeing double-digit growth in that end market again this year.

So, I think there's three drivers of the resi demand over the next three to five years growing as a multiple of GDP.

That's very helpful.

Thanks.

And I was wondering if you could update us on any change to the M&A environment?

I know you did the -- you've announced the buyback.

I presume that means there's -- it's still not as robust an opportunity set.

But maybe you can opine on what you are seeing and what you might expect to see over the next couple years.

Yes.

We are pretty selective about what we are going to do.

And so I'm not sure I'm a broad -- or I'm an indicator of the broad M&A market.

I mean, where we would want to do a deal first and foremost is consolidate the North American HVAC business.

That's a handful of properties; somebody would have to decide to sell.

And then we might do something in Europe, if that made sense, and we could get it at the right price to expand the strengthening business in Europe that we have.

And the share buyback just reflects, I think, more positively the strong cash flow we have in the business, the strong quarter that we have, and what we think remains in front of us for the balance of the year.

Okay.

And last question, just looking out a year, I was hoping you could just opine on what you think happens to CR14 pricing?

It has matched your expectations so far, but do you expect that that's going to be a big headwind -- a bigger headwind next year?

Any comments on that would be helpful.

No, I think it's -- I can't get the tenses right -- I don't know if I want to say it has shook or it has shaken out, but it's done all the shooking and shaking it's going to do, I think.

So we think we are at where we are at on 14 SEER pricing, that folks have sold out their inventories and it's stabilized about where we thought it would, which was somewhere between the old 14 SEER pricing and the old 13 SEER pricing.

And I think we avoided a big problem.

And we always thought that was how it would shake out, and that's how it has.

Okay.

Last one, for Joe, perhaps you can just frame for us the -- how large steel is, as an input, overall relative to your COGS?

I had it at under 5%.

Is that in the ballpark?

I actually think it's a little bit more than that.

Yes.

I mean, I think about it as -- I'll give you pieces of the math, because I haven't done it -- sort of the old math lately -- is it's about 70% or so of our cost of goods sold is material.

And then, if you take that material and blow it back up, about 35% to 40% of that 70% is raw copper, steel and aluminum.

And steel is the largest of the three.

Okay.

All right.

Thanks a lot, guys.

And our last question comes from the line of Steve Tusa with JPMorgan.

Please go ahead.

Just two very quick follow-ups.

How much is the -- that commods number, the commodity benefit this year, been so far for the first half?

(multiple speakers) The $35 million?

Yes, it's about $25 million or so.

$25 million of that $35 million?

Yes, okay.

And then did you have any down months in resi?

Say that one more time?

Did you have any down months in resi?

Down sales months in resi?

I'm pausing.

I don't think so.

I think we are up year-over-year, every quarter -- or every month.

Maybe in April, we may have been slightly down.

But honestly, I don't remember.

Right.

Okay.

Thanks a lot, guys.

Thanks.

Okay, great.

A few points to leave you with.

The Company set new record highs for margin and profit in the second quarter.

And we remain focused on driving performance.

We are raising EPS guidance for 2016 and initiating a new $100 million stock repurchase program for the second half.

The third quarter is off to a good start for all three of our businesses, and we continue to expect another record with strong -- record year with strong margin expansion and profit growth.

Thanks, everyone, for joining us today.

Ladies and gentlemen, that does conclude our conference for today.

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

You may now disconnect.