Lennox International Inc (LII) 2016 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International third-quarter 2016 earnings conference call. (Operator Instructions). As a reminder, this call is being recorded. I would now like to turn the conference over to Steve Harrison, Vice President of Investor Relations. Please go ahead.

Good morning. Thank you for joining us for this review of Lennox International's financial performance for the third 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. In addition, all comparisons mentioned today are against the prior-year quarter unless otherwise noted. You can find a direct link to the webcast of today's conference call on our website at www.lennoxinternational.com where we will also archive the webcast for replay.

We 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 or otherwise.

Before I turn the call over to Todd, I would like to announce the date of our Annual Investment Community Meeting. The event will be held the morning of Wednesday, December 14 in New York City. Please mark your calendars. Invitations and more details will follow. The meeting will also be webcast.

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 revenue growth in the third quarter at 6%, led by 11% growth in our residential business and the Company set new third-quarter records for operating margin and profit.

On a GAAP basis, operating income rose 24% to a third-quarter record of $157 million and operating margins expanded 220 basis points to a third-quarter record 15.5%. Lennox International saw strong margin expansion and profit growth across all three of our businesses to set new third-quarter highs for the Company.

Total segment profit rose 20% to a third-quarter record $157 million as total segment margin expanded 190 basis points to a third-quarter record 15.6%. GAAP EPS from continuing operations was up 32% to a third-quarter record of $2.33. Adjusted EPS from continuing operations was up 28% to a third-quarter record of $2.33.

In our residential business, we set new third-quarter records for sales, margin and profit. Segment profit was up 25% on the 11% revenue growth. Segment margin rose 230 basis points to 19.7%. Residential new construction revenue was up mid-teens and replacement revenue was up low double digits. Product mix was favorable with fewer low-end R22 dry charge and 13 SEER units sold than a year ago. This is partially offset by channel mix with new construction business continuing to grow faster than replacement business.

We opened up nine new Lennox PartsPlus stores in the third quarter and have opened 16 new stores year-to-date. The Company now has a total of 202 stores open and more than a quarter of our residential revenue flows through the stores. We are still planning a total of 213 stores by the end of 2016 and targeting 325 stores by the end of 2020. The PartsPlus stores have been enabling us to win new dealer contractors to Lennox and provide a high level of equipment and parts availability to new and existing dealers. The stores are a key element in our marketshare gain strategy.

Turning to our commercial business, revenue was up 2%; commercial margin and profit hit new record levels; segment profit rose 9% as commercial margin expanded 130 basis points to 19.5%. North America commercial revenue was up low single digits. We saw mid-single digit growth in replacement business while new construction revenue was down low single digits. National account equipment revenue was down slightly in the quarter. We continue to see strong wins for new national account customers; seven more wins in the third quarter. New national account customers include property, financial, telecommunications and service firms, as well as restaurants. Year-to-date we have won business with 27 new national accounts.

On the services side, national account services saw mid-single digit revenue growth in the third quarter. Non-national account revenue was up low single digits, and we continue to see strong growth in our VRF business in North America. In Europe, commercial HVAC revenue was down low single digits.

In refrigeration, revenue was down 2% for the quarter, primarily on the timing of national account business and soft market conditions in Europe. From a regional perspective in constant currency, Europe was down mid-single digits; North America, Australia, South America and Asia were down low single digits. Refrigeration revenue is up 3% at constant currency year-to-date and we continue to expect revenue to be up in the fourth quarter. Refrigeration profit rose 13% in the third quarter as segment margin expanded 160 basis points to 12.3%. For the full year, we continue to expect refrigeration margin to be up about 200 basis points from the prior year.

For the Company overall in 2016, our underlying market expectations for the year remain the same. We are well-positioned to continue to capitalize on market growth and drive Company initiatives for share gains. We are raising 2016 guidance for adjusted EPS from continuing operations based on the Company's strong operational performance and outlook. We continue to expect strong margin expansion and profit growth as momentum continues and we close out another record year. Now I will turn it over to Joe.

Thank you, Todd and 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 third quarter, revenue from residential heating and cooling was a third-quarter record $573 million, which was up 11%. Volume was up 10% and price and mix combined was up 1% on a revenue basis. Foreign exchange was neutral to revenue.

Residential segment profit was a third-quarter record $113 million and that was up 25%. Segment profit margin was a third-quarter record 19.7%, up 230 basis points. Segment profit was impacted by higher volume, favorable price mix, lower material costs and higher factory productivity. Partial offsets included investments in SG&A, distribution expansion and other product costs.

Now turning to our commercial heating and cooling business, commercial revenue was $251 million in the third quarter, which was up 2%. Volume was up 2% and price and mix combined was flat on a revenue basis. Foreign exchange was neutral to revenue. North America commercial HVAC equipment and service revenue was up low single digits while European HVAC revenue was down low single digits. Commercial segment profit was a record $49 million and that was up 9%.

Segment profit margin was a record 19.5%, up 130 basis points. Segment profit was impacted by higher volume, lower material costs and lower freight costs. Partial offsets included factory productivity and other product costs and investments in SG&A.

In our refrigeration segment, revenue in the third quarter was $186 million and that was down 2%. Volume was down 1% and price and mix combined was down 1% and foreign exchange was neutral to revenue.

From a regional perspective, Todd addressed revenue growth in constant currency. On a reported basis, South America was up mid-single digits; Australia was up low single digits; North America was down low single digits and Europe and Asia were both down mid-single digits. Segment profit was $23 million and that was up 13%; segment profit margin was 12.3% and that was up 160 basis points. Segment profit was impacted by lower material costs, lower factory costs and higher productivity with partial offsets, including lower volume, unfavorable price mix, unfavorable foreign exchange and higher SG&A.

Regarding special items in the third quarter, the Company had net after-tax charges of $200,000. This amount included a gain of $700,000 for the net change in unrealized gains on unsettled futures contracts and a charge of $400,000 for restructuring activities and $500,000 of charges for other items net. Corporate expenses were $27 million in the third quarter compared to $24 million in the prior-year quarter.

Overall, SG&A was $157 million in the third quarter compared to $144 million in the prior-year quarter. Net cash from operations in the third quarter was $148 million compared to $159 million in the prior-year quarter. In the third quarter of this year, the Company had a $50 million use of cash for discretionary pension contributions. Capital spending was $18 million in the third quarter compared to $14 million in the prior-year quarter. Free cash flow was $130 million compared to $145 million in the third quarter a year ago.

We ended the third quarter with approximately $1.1 billion of total debt and had a debt-to-EBITDA ratio of 2.1. We paid $19 million in dividends in the third quarter and paid $100 million in conjunction with an accelerated share repurchase program being executed over the third and fourth quarters. And at the end of September, cash and cash equivalents were $48 million.

Now, we will review our outlook for 2016. Our underlying market assumptions remain unchanged. For the industry overall, 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 America refrigeration shipments to be up low single digits.

With a quarter to go in the year, we are now narrowing our guidance for 2016 revenue growth from a range of 3% to 7% to a range of 4% to 6%. We still expect foreign exchange to be neutral to revenue on a full-year basis.

We are updating our guidance for GAAP EPS from continuing operations from a full-year range of $6.45 to $6.85 to a new range of $6.25 to $6.45. The new range incorporates special items to date and the impact from approximately a $20 million after-tax or $30 million pretax non-cash pension charge expected in the fourth quarter. This relates to our ongoing strategy to de-risk our pension plan obligations. In the fourth quarter, we expect to complete a one-time lump sum pension buyout for certain vested participants. This action is expected to reduce the Company's pension obligations by approximately $50 million.

Looking more on an operational basis, we are raising guidance for adjusted EPS from continuing operations for the full year from a range of $6.50 to $6.90 to a new range of $6.75 to $6.95 based on the Company's performance year-to-date and outlook.

Let me now walk you through the drivers to our guidance and the puts and takes for 2016. We still expect a $45 million benefit from commodities and price combined. Within this total, we are raising the commodity savings from $35 million to $40 million and fine-tuning the price benefit from $10 million to $5 million. In addition, foreign exchange is now expected to be a $5 million headwind for the year versus prior guidance for a $10 million headwind.

Other guidance points that are changing, we now expect a $45 million benefit from sourcing and engineering-led cost reductions compared to prior guidance of $40 million. For corporate expense, we now expect $95 million for the year compared to prior guidance of $90 million as we continue to invest in the businesses for growth.

A few guidance points that remain unchanged. We still expect residential mix to be relatively flat in 2016. We continue to expect $11 million of incremental savings this year from our second plant in Mexico. Net interest expense is expected to be nearly $29 million for the full year. Our effective tax rate on a full-year basis is still expected to be approximately 31%, which equates to about a 34% rate for the fourth quarter. Looking beyond 2016 to future years, we expect approximately a 32% effective tax rate.

The weighted average diluted share count guidance for 2016 overall remains approximately 44 million shares. We continue to target capital expenditures at $95 million for the full year, and our free cash flow target remains approximately $200 million for 2016. And with that, let's go to Q&A.

(Operator Instructions). Jeff Hammond, KeyBanc Capital Markets.

Can you maybe just -- incrementals continue to be strong. You bumped up your commodity number. How are you thinking about that into the fourth quarter and then just price cost into 2017? I know you announced some price increases here recently.

Yes, we think the momentum continues in the fourth quarter. As we've talked about before, we have pretty good visibility to our commodity costs and have hedged them out or have negotiated them out on the steel side. We saw mix up in resi in third quarter and we think that continues as we go into fourth quarter. So fourth quarter setting up nicely from a margin viewpoint.

For 2017, maybe I will just answer more than you asked for, Jeff. I will just talk about 2017 maybe a bit more broadly and cover the points you asked. We will have the Analyst Day in December, but just a couple comments. Our end markets, we've had nice momentum this year in the low to mid-single digit range of end-market growth and while there are always risks, we don't see anything today that alters that range as we roll into 2017.

In addition, we are winning in the marketplace in North America residential and commercial unitary markets, so a half a point or more of marketshare gains and we think that continues as we go into 2017. We've had a nice material cost reduction this year and we recently -- in our current guidance, raised that by another $5 million to $45 million. More typically, we are $30 million to $40 million of savings and that's what you should expect us to deliver next year. (inaudible) $5 million of benefit in 2017 from things we've announced already in Mexico.

Specifically on the question you asked, for commodities at this point, we expect copper and aluminum to be a tailwind, so a net benefit and steel will be a headwind, but prices have moved around. Spot prices went -- for the cold rolled we buy -- spot prices -- not what we pay, but spot prices went from about $5.25 to as high as $8.35 when we had the last call, but it's been coming back down and now is around $715, so down from $835 to $715. So for this headwind in steel, we think we can cover it with price increases next year. We've already announced a price increase in commercial of about 5% for next year and as we get closer to the end of the year, we will announce something similar in res. So the Company has good momentum and we expect another strong year in 2017.

Okay. And then just a quick follow-on. You cited some softness in Europe in some of the international markets. Just talk about what's driving that and how you are thinking about that prospectively.

In Europe, we have 40% or so of our business is what we call emerging markets -- Eastern Europe, Middle East and North Africa. And so some of the headline risks, geopolitical risks in those markets are well-known and so we've had some drawback there. But overall in our core markets -- France, Germany -- things remain solid and so we had a quarter where we dipped down, but we still, again, think it's going to be a flattish market, slightly up as we go into 2017.

Thanks a lot.

Stephen Tusa, JPMorgan.

I guess wondering about price. You tweaked down price again this quarter. What's going on there? Is that just how the comps have played out, maybe timing of price increases last year? I'm just curious as to why you guys are tweaking that down.

Overall, we still remain confident on price. I think it just reflects the issue, or the fact that FX was less of a headwind than what we thought, so our ability to get price in Canada, we came to the conclusion that when FX has moved our way, it's hard to pass that price on and also the commodity inputs, we continue to release increasing positive news on commodities.

On 14 SEER pricing, it's been expected, or has been expected and as I talk about with Jeff, we are positioned to announce price increases for next year. So I wouldn't read too much into the price other than it's hard when you have such a benefit from commodities and a minimal headwind from FX to be too aggressive on price and that's what we are reflecting.

Got it. And what do you think the end-market growth rate was in the third quarter for resi because you said you took a little bit of share at 11%? What do you think the end market did?

At least I didn't try and specifically call that we gained share. I think what I said is, on a rolling 12-month basis and over a longer term, we are clearly gaining share. I'm not sure what third quarter is going to be. Again, whether you look at HARDI or whether you look at AHRI, there are timing implications to both those, so we will see. I think we had a nice quarter.

Okay. Anything about the heating season that's coming up in the fourth quarter that's unusual, whether it's last year's weather or regulations? Sometimes these heating seasons can bump around a bit. Anything unusual here in the fourth quarter to keep our minds on?

I think the only thing to keep -- everyone understands is last year it was a warm fourth quarter, so if we have cooler weather, more normalized weather, that should be a net positive. That's in our guide. We are off to a solid start. October is a shoulder season. It's been warm, which we need it to now turn cold, but we are off to a nice start. And, again, if we can grow on a year-over-year basis furnaces, that has a positive mix impact and again, that's in the guide, but that will help us in fourth quarter also.

Sorry, then one more. You talked about backlog in commercial in the past. How does the backlog look in your commercial business?

The honest answer, I don't have that note in front of me. What I would say though is we were up low single digits in commercial in Q3 and we had some headwind from Walmart. Walmart aside, our national account business was up double digits and our non-national account business was up low single digits and we expect that momentum to continue in fourth quarter, not with Walmart. I think their travails are well-known, but all these national account customers that we are winning are coming to fruition and we have some nice momentum as we go into Q4.

Super. Thanks a lot, guys.

Gautam Khanna, Cowen and Company.

Thanks, good morning. I was wondering if you could talk a little bit more about your expectations for the Walmart mix next year. Is there a chance it actually improves and when will you actually know?

We will know a lot more as we get closer to 2017 and so we will have to wait and see. And it cuts across both our commercial businesses, both HVAC and refrigeration and they clearly announced on their earnings call -- I believe it was their earnings call, or at least on a call -- that new stores were down pretty significantly. We understand that. What they are doing on -- they also announced that they were going to increase spending on CapEx for replacements and we are still just working through with them all the details. So, in December, we will probably give a little bit more guide on what we expect for that mix of business.

Okay. And just at a high level, you gave some of the inputs for 2017. Knowing what you know now with the commodity movements and the like, is there any reason that the 30% incremental framework off of what is a tough comp this year isn't in place for 2017? It sounds like many of the things you described support that 30% framework even next year.

I think plus or minus -- I've said in the past that given our overdelivery this year that we might have a drawback in the outlying years, but still be on track for a three-year 30%. Where I sit today, plus or minus 30% dropthrough for 2017 feels pretty good.

And will you comment on 2019 as well when the December guide comes around?

Yes, yes, we will. If you play out where we are in our businesses, we are already well into the margin targets for 2018 already in 2017. So we will touch those up in December.

Thanks a lot, Todd.

Tim Wojs, Baird.

Good morning. I guess just on -- I'm going to try to tie a couple things together. I don't know if you will answer it, but if volume trends into next year, there's not really any trend and you guys should expect to get some pricing to offset commodities, is the implication that revenue growth can accelerate in 2017?

I think it could, and one way to think about it is our revenue grew 6% in third quarter. That accelerated over the first half of the year. So I think when there's more of an inflationary environment, as long as the underlying demand stays in place, if we mix up, we price up and we gain volume, yes, it could. But there's a lot of crosscurrents going right now. I think that's a most comfortable answer for residential. I think in the commercial and refrigeration end markets, there's moving pieces, including some large customers like Walmart, as well as just underlying demand.

So that's a long song and dance to say I'm not going to directly answer your question other than to say the tone of my comments for 2017 were to exhibit confidence. Things are trending well. Our end markets feel solid and we feel like we are gaining share.

Okay. And then just a bigger-picture question with just some of the stuff that's come out with the Montreal Protocol over the weekend. The transition away from HFCs, how do you see that impacting Lennox's business longer term?

For the broader audience, there was a conference -- I think it was over the weekend -- in Rwanda and it was an extension of the Montreal Protocols. As you may recall, the Montreal Protocols initially had a dropdown for HCFCs, which was R-22 and 2020 was the end date and it's basically out of our industry as of today -- as we sit today; and Rwanda was an extension to focus on HFC refrigerants, which is 410A, which is a major refrigerant in our productlines.

I think the points I'd make was expected. We knew it. We are very close to it. In fact, we are supportive of it. We think it's the right thing to do for the environment and quite frankly the right thing to do for our industry. We have options and technology in place that we are fine-tuning both with our refrigerant suppliers and our compressor suppliers.

And then the third point is just the timing of the implementation, although I'm not totally clear as we make sure we understand the total agreement is this is really a decade off before it has any significant impact on our business. So this is mid-2020s. I think the drawdown starts in 2019 overall, but before it really starts to impact our business, it's probably mid-2020. So it's a decade or so away and we will be well-positioned when it happens.

Okay. Thanks, guys.

Ryan Merkel, William Blair.

Thanks. Just want to go back to October. You said it was a good start, but was there any impact from the hurricane, any branch closures? Is it going to have any impact on October?

No. There may have been a few branch closures, but it won't have any impact on October. Or better stated, certainly won't have any impact on the quarter.

Right. Okay. And then new commercial construction was down in the quarter. Is there any end markets that stand out and any early thoughts on 2017?

No, nothing other than I've said. Part of the driver -- I talked about Walmart. Walmart does a lot of new construction, so I think in some ways the Venn diagram overlaps on my commentary on new construction. So the short answer was mainly -- or the biggest driver was the retail vertical. So as we go into 2017, we will true up the guidance, but both our momentum and customers we are winning and a call that says we are up low single digits this year and my commentary that, at least as we stand now, we probably think that continues into next year. We will true up the guidance specifically on some of the subsegments in December.

Okay. And just quickly, the pushed-out national account business in refrigeration, what caused that? Can you size it for us and does it hit in the fourth quarter, or is it next year?

I think some of it pushes into 2017. I think the point I would make would be, at least where we sit right now, we think refrigeration revenue will be up in fourth quarter. That's after some decent comps last year fourth quarter, and it was just some big business. A big piece of it was Walmart, quite frankly, that pushed out and we probably won't see that until 2017; or better stated, it's pulled out of the system maybe. And then some of the other national accounts got pushed from third to fourth quarter and we will see the benefit then.

So I think the message I would leave you with is, at least right now, we think we are going to be up low digits or so in refrigeration revenue and again, it's early in the quarter so that may move up or down.

Got it. Thank you.

Rich Kwas, Wells Fargo Securities.

Good morning. This is Deepa Raghavan for Rich Kwas. North American non-residential outlook, you addressed this a little bit for your market. There is serious concern it's slowing down. You mentioned retail is slowing just given your Walmart exposure, but any other color you could share across other verticals, especially institutional or any other commercial verticals?

Yes, my sense where people are most concerned about non-commercial -- on non-res or in the larger buildings where we don't play, large institutional, large office buildings, large government facilities, we don't play there. And our verticals continue to slug along low single digits we've seen in growth. So our non-national account business we said was up low single digits. Outside of Walmart, we were up nicely in national accounts. So we think the verticals that we play in -- buildings three story and below, which is retail, which is convenience, which is grocery, which is small medical, doc-in-a-box, which is K-12 -- we continue to think it feels pretty solid.

Okay. Your implied Q4 guidance range, $1.29, $1.49, just given your recent performance, it appears pretty conservative. Could you please talk to some of the concerns that you have especially to the lower end? Why would you think it could get to $1.30? We probably can appreciate some upside to it, but just curious what your puts and takes are.

I think you always have a range. We live in an uncertain world. There's always weather that's in the mix here. There's a pretty controversial presidential election going on and you are never sure what's going to shake out on that. My tone today is supposed to reflect, or was intended to reflect confidence in the business and we feel pretty good as we go into the year -- as we go into fourth quarter, and we need it to get cold and we need consumer confidence not to be too shaken by some of the crazy statements that are being made, but, again, we feel pretty good in fourth quarter.

All right. Thank you very much.

Robert Barry, Susquehanna.

Good morning. So 3Q revenue in resi, was that ahead of your plan?

Yes, the hot weather helped.

Yes. How much do you think whether benefited the quarter?

This is a non-quantified answer, Robert.

Yes, I know it's hard to quantify, but just --?

I've often said hot weather in the middle of a summer season could help plus or minus 5%, 10%, but I think if you take the average overall for the quarter because when you get into September, as you are walking away from it, I would say 3% or 4% if I had to through a dart.

Got you. Like 3 to 4 points of the growth?

Yes.

Got you. Okay. So maybe just following up on the last question, it sounds like with the midpoint of the revenue outlook unchanged despite this stronger result here, it's just maybe some added caution about the warm start to the quarter?

I also think it has to just do with the round on a full-year guide when you get to the end. So if you take 3% to 7% and compare it to 4% to 6%, the 4% to 6% is actually a higher number than the 3% to 7%, if that makes sense just because of the round what's underneath it.

I see. Okay. Do you think that the peak for price cost was in 2Q, or that happened this quarter?

I think it was probably -- the high point was Q2, just given the 100% dropthrough. We had a great drop through this quarter but it wasn't 100%.

Yes. Given your commentary on price cost in the last few months and the fact that steel has come off, it almost sounds like if we snapped the line now, maybe price cost could even be a slight positive next year? Is that right?

If you include -- are you including material cost reduction, or just commodities versus price?

I guess however you want to say it.

Well, if you include (multiple speakers).

Commodities versus price.

Commodities versus price, I think we've tried to signal that we can cover commodities with price even when it was at $835 and so now that it's come back, I think you can draw some conclusions that it could be positive. We will have to see. And then material cost reduction is clearly above and beyond that and Mexico is clearly above and beyond that.

Right, right. You referenced in an earlier question about the price outlook ticking down. I think you referenced pressure from the SEER 14 repricing. How much of a headwind is that? Is that most of the reduction?

No. Let me restate my answer to that question in the way I meant to say it, which is the tickdown in our pricing guidance for the full year was really driven by the fact that commodities continue to be such a large benefit for us. We thought they would start to decrease second half of the year and that, therefore, we would be able to get more price. And then also specifically in Canada, we thought FX would be a significantly greater headwind than it's turned out to be and we recently -- and we just reduced our FX headwind from $10 million to $5 million. So when you have your costs going down, it is just harder to get price and so that's what it's reflecting. So net-net between commodities and price, we are getting $45 million of price and commodities. That's a pretty big number.

Got you. And maybe just lastly, the corporate line is ticking up. I guess it makes sense to invest a little more now given times are good. Could that be a nice tailwind next year? Would we expect that to tick back down again, that corporate line?

Yes. I would expect it could tick down a little bit because it's a couple things. It's investments we are making for growth and then it's -- when you have a nice year and a nice quarter then, incentive comp gets spiked up and then for the next year, you zero baseline it.

Right. Makes sense. Great. Thanks. Congrats on the solid quarter, guys.

Julian Mitchell, Credit Suisse.

Yes, and this is more of a question I guess for next year in the medium term, but obviously a couple of your larger US resi HVAC competitors, there are some substantial changes going on in their production footprints in the next 18 months. I just wondered what you thought the impact of that might be on industry pricing. And obviously, you have been pretty far ahead in terms of migrating your cost base in a very efficient way. Do you think that if you see a change in industry competition, you may need an acceleration in those types of measures, or what you've enacted already should be sufficient?

I will take the back end first. We've consistently said we are not done moving to Mexico, and we are not. And so we will continue to, in your words, do it in an efficient way and a thoughtful way and a way that we don't miss customer orders. I assume the two things you are talking about is Goodman Daikin consolidating in Houston. I don't think that changes anything. We do over half our resi in Saltillo, south of where they are in Houston and we will take our cost position versus theirs. I'm not sure that helps their costs.

I assume the other one is -- I watched Trump's speeches, so he's talked about Carrier quite a bit moving to Mexico, so I am well aware of that.

Right.

No, I think they separate cost and price. I think the way I view it is let's see them execute it. It's not so easy to move a factory and their Indianapolis factory is well-run; and let's see them move it to Mexico and be successful at it. And if they do all that and do all of that in 18 months then they will make more margins. I don't think they will pass it on in price, but let's see if they can execute, and if they don't, we will take advantage of it with share gains.

Very clear. And then my second question would just be circling back on the refrigeration segment. Obviously, it's been choppy organic trends this year quarter-to-quarter. When you think over all just medium-term growth rates, do you think of a low single digit rate is appropriate in terms of when you are thinking about your cost base? And also I think you talked about some SG&A increases in spending in refrigeration in Q3. Maybe give us some color as to where you are investing in that business as clearly there is a lot of pricing pressure.

I think we have to make significant investments -- or we have made significant investments in taking costs out of the business. So you may invest in SG&A, but then you drive costs and COGS other places and that's what we've been doing. We also know that we have to make investments to serve our customers. So e-commerce, online tools, things that we have to do to automate the business for our long-term marketshare success.

I think if you look at macro refrigeration for the end markets we play, it's something equivalent to GDP over time, but I think there's chunkiness to our business. We have an overexposure quite frankly to Walmart so that has some impact on any given quarter and we, especially in our Kysor/Warren business, have talked how we are focusing on diversifying that and we are.

So I think there's some ups and downs in refrigeration, but some of our larger refrigeration competitors, like Dover, have talked about the pressures on the market, maybe more as a macro comment. We are more concerned about the micro, winning customers, serving our customers, and if we do all that, I think we will be fine with what the end markets are doing.

Great. Thank you.

Josh Pokrzywinski, Buckingham Research.

Todd, just in your earlier comments on look at share over a 12-month period, I'm wondering if you can break that out for us; how you guys have trended year to date. I think depending on whether or not you look at HARDI or HRI, it looks like, I guess just on the surface, maybe some underperformance. Is that just a year-to-date issue and if I do look back over the last two years, you feel like it's been more consistent, or anything that you can point out that would help to maybe bridge the difference?

I found the best -- and some of this data you won't have -- but we found the best way to look at share over time is rolling 12-month AHRI data where you look at unit shipments, and so you take out price, you take out mix and you just look at unit shipments and 12-month roll, we are gaining share and we have for the last four or five years in residential.

In commercial, we are flat to slightly down on a 12-month roll and that just reflects quite frankly the Walmart business. When you adjust for Walmart, we look good there also.

Got you. And I think, obviously, a lot of attention paid this quarter especially to the weather strength and maybe to some extent the weather weakness in 2Q. But if you had to roll it all up into I guess a non-scientific opinion, do you feel like, on net, having gone through all the season at this point that it was normal weather, just maybe a little asymmetric, or kind of a net tailwind?

I haven't run the math.

If you want to be scientific, that's fine too.

No, I understand. I think net-net we'd rather have blistering heat in May, June and July than we would in July, August and early September, and I think that's the trade we made this year. All that being said, we will take what we get, but if I was modeling next year, I would think first half of the year, we have favorable comps; third quarter, we have some headwind on a weather comp and we will see how fourth quarter plays out.

Got you. And just one last one. More broadly, it doesn't sound like you are seeing any signs of this from a pricing perspective, but you guys have been consistent share winners really since you took over back in 2006, Todd. And I guess in that environment, especially with the industry margins here pretty high, what gives you the confidence that you don't see some of the repeats of what your competitors had done a cycle and two cycles ago in terms of ruining that margin environment through price maybe to reclaim some of that share, or do they try to reclaim share in other non-price ways?

I think it's an industry structure that's always allowed very high margins. Even in the last cycle, we weren't the margin leaders, but from public documents, Carrier and Train in resi had high teens and Unitary had similar margins. Over the long period of time, people talked about Goodman lowering prices and competing with price, but every time they sell the business, they show publicly that they have 15% operating margins, so they know how to make money.

So I think as long as the industry structure is as it is, there's a handful of competitors selling to thousands of dealer contractor customers with a consolidated supply base that we can leverage against each other, I think we continue to make good margins. And so I don't think price will be the way people will go. I think they will try to innovate to compete against us, but I think we have made significant investments over a multi-year time period both on our product innovation and our support to the channel; think e-commerce; think Lennox Pros and the things we do online. We made significant investments in distribution over a multi-year period and it continues. Those are investments that are hard to compete against unless you want to do the same thing for a very long period of time and we will see whether our competitors do that.

Got you. Appreciate the color. Thanks, guys.

Shannon O'Callaghan, UBS.

Good morning, guys. Maybe just on mix, the SEER shift and the Walmart stuff has been front and center. Anything else as we are thinking into 2017 that we should keep in mind in terms of mix when you look across the three businesses that's going to go either for you or against you?

I think the one thing I would think about is traditionally what's happened is when you snap -- and I think it ties to the 14 SEER point -- when you snap the line on a new minimum efficiency, you then have a baseline that the premium players start to mix up from there. And I think we will probably see some of that in 2017 and beyond, all things being equal. So, again, we've demonstrated that we know how to mix up in resi. We know how to mix up quite frankly in our other businesses too and I think it will continue in 2017.

Okay. And then maybe just on this pension decision, what drove the choice to do that now and what are the mechanics from a cash flow and P&L standpoint as we look forward?

Yes, the rationale behind it was, once some of our tax initiatives afforded us the opportunity to efficiently repatriate some cash from our international subsidiaries, then we thought it was the prudent thing to do, would be to contribute that to the pension plans in 2016. Along with that, we've had a continued opportunity to derisk our pension plan, so a combination of making that contribution, along with the buyout that we announced as well will give us an effort and an opportunity to reduce our pension obligations and more effectively manage the asset and liabilities going forward.

So looking forward at what the implications of that are, our pension expense in 2016 was a little more than -- or just under $7 million and we should get a little bit of a benefit as a result of making the contribution and then reducing the obligation going forward. And we will talk more about the implications of that going forward, but it should provide us a slight benefit in 2017 and beyond.

I will jump in and maybe I'm the only one who has a tendency to get confused on these sort of things, but I think we tried to make it very clear in the press release, but two actions taken, as Joe talked about, and the numbers both start with 5, so it gets confusing. But one was -- independent of anything else was we pay down our pension with a $50 million contribution. The second item we did was we bought out people with lump sum payments. Two different actions that had two different P&L balance sheet implications. And we did it all under the rubric of derisking pension plans.

And then, Shannon, in the fourth quarter, you will see an approximate $20 million non-cash net charge for the implication of the buyout program. That's in essence us expensing deferred losses on the pension plan.

Okay. All right. That helps. Thank you.

Stephen Tusa, JPMorgan.

Just two quick follow-ups. Buyback appetite for next year, what is the current status now that you've rounded out the other program, what's the current view on buybacks?

Look, I'm going to tell you what you know, but we are not going to give a number right now, but what I would do is I would model 2017 P&L. I would model cash flow at 100% of net income. I would say that we are not going to delever and that we said we are going to be between 1.5 and 2.0. And so just lay it out and we will have dividends grow with earnings. We will do an acquisition if it makes sense, but it's been a while since we've done any and in lieu of that, we will do share buyback.

And one thing I will add to that too. Capital expenditures will probably be similar to what they were in 2016 as well.

Okay. And then when you guys reengineer a product and you make it smaller with less material, how do you account for that in the bridge? Is that part of the sourcing savings, or does that come through in better core incremental margin because I assume that you don't give all those savings away obviously to the customers in price?

Typically, it's a material cost reduction and so (multiple speakers).

Got it, so it's part of the initiatives?

Yes. If we can quantify it and see the target and shoot it, then we put it in MCR.

Got it. Sorry, one last one. You made some comments on non-res. Maybe if you could just talk about -- do you think you have a good window to the applied area, or are you much more talking about what you are seeing in your unitary business when you talk about the different verticals or do many of these run together now with VRF, etc.?

I may have stepped past what I should have said. I have visibility to what we do and it's fine. I was just reacting to -- I don't want to put words in -- I forget who asked the question, but it was almost sort of a breathless, non-res is trembling, are you concerned. And so I assume the questioner heard that from others. In the verticals we play in, it's not trembling and while we are always concerned, it's holding up nicely.

Yes. Okay, awesome. Thanks a lot.

Walter Liptak, Seaport Global.

I just got a couple of quick ones. On the sourcing engineering, you kind of touched on it with the last question, but as you think about that, what inning do you think we are with designing out costs and becoming more efficient on design of products?

I think we just continue to do it. I joke with the team that I was at UTC for 15 years and the cost-reduction train never ever stopped and I assume it continues to run even though I'm not there. And so we've been at this six or seven years and it continues. We've gotten much better at things like computational analytics, our ability to model systems and quickly cut in changes. Where in the past it might take a year or two of field trials, we are able to cut in changes in major components and subassemblies and new systems much quicker and look at different options. We are able to use software rather than hardware. We are able to use aluminum rather than copper and so we are still -- lots of material cost reductions still in front of us.

Okay. All right. That's great. So you haven't really called it out too much -- answered quickly on the hurricane-related question, so I am reluctant to ask this, but I will anyways. What percentage of revenue is in those affected states and any thoughts on the flooding that's gone on down there? They are going to have to rebuild and there's going to be, I guess, insurance proceeds at some point. Maybe any thoughts on how that impacts 2017?

I understand the question. We haven't quantified it, so I haven't gone through and asked the team in coastal Florida and coastal Carolina what was the impact, what's our best guess. Florida is obviously a big market. Carolina is a big market. Some of it will flow through, but I don't -- we are not sitting internally counting all the sales we are going to get because of that. I think it will be sort of a rounding number, but it's a good question and you are the second person to ask it. In December, we will have a better view on that and if it's material, we will talk about it.

Okay. Fair enough. Thanks.

We have no further questions in queue at this time.

Great. Thanks. A few points to leave you with. The Company set new third-quarter highs for margins and profit on strong revenue growth in the quarter. We are raising 2016 guidance for adjusted EPS based on the Company's performance year-to-date and outlook. With continued momentum, we remain focused on driving performance and closing out another record year with strong margin expansion and profit growth. Thank you all for joining us today.

Ladies and gentlemen, that will conclude your conference call for today. Thank you for your participation and for using AT&T's Executive Teleconference Service. You may now disconnect.