Lennox International Inc (LII) 2017 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Lennox International Second Quarter 2017 Earnings Conference Call.

(Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to Steve Harrison, Vice President of Investor Relations.

Please go ahead, sir.

Good morning.

Thank you for joining us for this review of Lennox International's financial performance for the second quarter of 2017.

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

Todd will review key points for the quarter.

Joe will take you through the company's financial performance and outlook.

(Operator Instructions)

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.

All comparisons mentioned today are against the prior year period, unless otherwise noted.

You can find the direct link to the webcast to 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 risk and uncertainties that could cause actual results to differ materially from such statements.

For information concerning these risk 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.

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

Thanks, Steve.

Good morning, everyone, and thank you for joining us.

Lennox International posted a strong revenue and profit growth in a record quarter, in which the company hit new all-time highs of revenue, total segment margin and profit and earnings per share.

Company revenue was up 8%, led by 14% growth in our Residential business.

On a GAAP basis, operating income rose 9% to a record $175 million.

GAAP EPS from continuing operations was up 8% to record $2.71.

On an adjusted basis, total segment profit rose 14% to a record $183 million, and total segment margin expanded 80 basis points to a record 16.6%.

Adjusted EPS from continuing operations rose 12% to a record $2.83.

Turning to highlights-- to the highlights in our business segment for the second quarter.

In Residential, the 14% revenue growth was driven by strength in both replacement and new construction business.

Replacement revenue was up low double digits.

New construction revenue was up more than 20%, as the team continues to execute well in serving the needs of national, regional and local builders.

Residential profit was up 21%, as segment margin expanded 130 basis points to 21.5%.

On the operational front, we continued to invest in R&D and IT to support initiative new -- innovative new products in the future growth of the business, as well as investments to further expand our distribution footprint.

We opened 3 new Lennox PartsPlus stores in the second quarter to bring the total to 216 stores.

We continue to focus on both opening new stores and leveraging our existing investments by driving same-store sales growth.

In Mexico, we are on track to realize $6 million of savings this year at our manufacturing operations.

Turning to our Commercial business.

We have seen lumpy customer demand and mix in the first half of this year.

We had a record first quarter with Commercial revenue margin and profit showing strong growth.

In the second quarter, revenue was up 3% at constant currency with segment margin down 140 basis points to 17.3% and profit down 6% from the record second quarter a year ago.

Commercial margin decline in the second quarter was impacted by 2 factors.

First, we had large orders from certain national account customers that were a lower product mix for us that shipped in the quarter and (inaudible).

National account business has longer lead times in realizing the benefit from price increases, as contracts are in place come up for renewal over time.

In the second quarter, we still had commodity cost ahead of the price benefit.

All that being said, as we look to the second half, we expect commercial revenue, margin and profit to be up from the prior year period.

Looking at the commercial revenue drivers in the second quarter.

Replacement revenue was up high single digits on strong growth in both planned and emergency replacement.

Commercial new construction revenue was down mid-teens year-over-year in the second quarter after being up mid-teens year-over-year in the first quarter.

Overall, North America commercial equipment revenue was relatively flat, both for national accounts and non-national accounts.

Looking at new national account equipment business, Lennox won 12 new customers in the second quarter on top of the 14 wins in the first quarter for a strong first half of new business for the future.

New customers in the second quarter included healthcare facilities, restaurants, retailers, hotels and property management firms.

On the Commercial service side, our national account service business showed strong growth in the second quarter, up mid-teens.

Our VRF equipment business showed nice growth again, and in Europe, Commercial HVAC revenue was up high single digits in the quarter.

In Refrigeration, revenue was down 1%.

From a regional perspective at constant currency, Europe was down more than 20%; and North America, South America and Australia were up low single digits.

Asia was up low double digits.

Refrigeration profit rose 1%, as segment margin expanded 30 basis points to 11.4%.

We continue to expect segment margin to be up 50 to 100 basis points on a full year basis.

With our strong balance sheet, we continued to make key investments in the second quarter to drive the future growth and profitability of the company.

Beyond that, the company paid $18 million in dividends and $100 million for stock repurchase in the second quarter.

We plan on $75 million more of stock repurchases in the second half of the year to bring the total to $250 million for the full year.

Now I'll turn it over to Joe.

Thank you, Todd, and good morning, everyone.

I'll provide some additional comments and financial details on the business segments for the quarter, starting with Residential Heating & Cooling.

In the second quarter, Residential revenue was a record $654 million, up 14%.

Volume was up 13%, and price and mix combined was up 1%.

Foreign exchange was neutral to revenue.

Residential profit was a record $141 million, up 21%, with segment profit margin expanded 130 basis points to a record 21.5%.

Segment profit was positively impacted by higher volume, favorable price and mix, sourcing and engineering-led cost reductions and favorable warranty and other product costs.

Partial offsets included investments in research and development, information technology and other SG&A, as well as investments in distribution expansion.

Partial offsets also included higher commodity costs and unfavorable foreign exchange.

Now turning to our Commercial Heating & Cooling business.

Commercial revenue was a record $259 million, up 2%.

Volume was up 4% and price and mix combined was down 1%, with foreign exchange having a 1% negative impact.

Commercial segment profit was $45 million, down 6%.

Segment profit margin was 17.3%, which was down 140 basis points.

Segment profit was impacted by unfavorable mix, higher commodity costs, investments in research and development, information technology and other SG&A.

Partial offsets included higher volume, sourcing and engineering-led cost reductions and favorable price.

In Refrigeration, revenue in the second quarter was $190 million, down 1%.

Volume was down 1%, and price and mix combined was flat.

Foreign exchange was neutral to revenue.

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

On a reported basis, Europe was down more than 20%.

All other regions were up.

North America and Australia were up low single digits.

Asia was up mid-single digits and South America was up mid-teens.

Refrigeration segment profit was $22 million, up 1%.

Segment profit margin was 11.4%, up 30 basis points.

Segment profit was positively impacted by favorable price mix and sourcing and engineering-led cost reductions.

Partial offsets included factory productivity, investments in research and development, information technology and other SG&A.

Overall, for the company on an adjusted basis, the second quarter excludes net after-tax charges of $4.6 million, including $3.4 million for special product quality adjustment; $1 million of special legal contingency charges; $900,000 in total for other items; and a benefit of $700,000 for excess tax benefits from share-based compensation.

Corporate expenses were flat in the second quarter at $24 million.

Overall, SG&A was $169 million in the second quarter or 15.3% of sales compared to 15.6% in the prior year quarter.

Cash from operations in the second quarter was $59 million compared to $76 million in the second quarter a year ago.

Capital spending was $18 million, flat with the prior year quarter.

Free cash flow was $41 million compared to $58 million in the second quarter last year.

Total debt was $1.19 billion at the end of the second quarter, and we ended June with a debt-to-EBITDA ratio of 2.1.

Cash and cash equivalents were $61 million at the end of June.

Now before I turn it over to Q&A, I'll review our outlook for 2017.

Our underlying market assumption for 2017 essentially remains the same.

For the industry overall, we expect North American residential HVAC shipments to be up mid-single digits.

We expect North America commercial unitary shipments to be up low single digits, and we expect North America Refrigeration shipments to be up low single digits.

Based on this underlying market environment, our targets for market share gains and the company's performance in the first half and outlook for the second half, we are raising the low end of our revenue guidance from 3-point -- from a range of 3.7% to a new range of 4% to 7%.

We still expect a minimal impact from foreign exchange.

For GAAP EPS from continuing operations for the full year, we are narrowing our guidance from a range of $7.65 to $8.25 to a new range of $7.73 to $8.13.

This incorporates the charges for special items taken this year, and our latest guidance range for adjusted EPS.

We are raising the low end of our guidance for adjusted EPS from continuing operations by $0.20 from a range of $7.55 to $8.15 to a new range of $7.75 to $8.15.

Let me now run through the key points in our guidance assumptions and the puts and takes for 2017.

First, on the guidance points that are changing.

We now expect commodity headwinds of $20 million in 2017, up from our prior guidance of $10 million.

We are also updating our effective tax rate for 2017 from approximately 32% to a range of 31% to 32% on an adjusted basis for the full year.

Now for the guidance points that remain the same.

We continue to expect $35 million in savings from our sourcing and engineering-led cost-reduction programs.

We continue to expect a $20 million benefit from price increases for the year.

We expect $6 million in savings from our manufacturing operations in Mexico for actions already taken.

We expect Residential mix to be a $5 million benefit for the year, and we expect minimal impact from foreign exchange.

A few other guidance points that are unchanged.

Corporate expense is expected to be $85 million for the full year.

We still expect net interest expense of about $32 million.

We continue to expect the weighted average diluted share count for the full year to be between 42 million to 43 million shares, which incorporates plans for a total of $250 million of stock repurchases for the full year.

Capital expenditures are expected to be approximately $100 million, and we are targeting free cash flow of $285 million for 2017.

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

(Operator Instructions) First with the line of Tim Wojs with Baird.

So maybe just starting with the Residential guidance.

Just given the full -- the good start to the year.

I mean, any commentary on if that could have been nudged higher a little bit?

Just given how Q2 trends has been, and then maybe any commentary on how things have trended in July here.

I think you have a little tougher comparison in the third quarter.

Yes.

I mean, our guide on Res for the full year is always the market guide for volume, is-- isn't meant to reflect what we think the revenue is going to be.

After a little bit of perceived weakness, and I think in first quarter by investors, we had a really nice second quarter, no days adjustments.

It was up 14% on revenue.

And the answer for Q3 is we're off to a nice start.

I know there's been some concern from the weather comps of Q3 last year, at least through the first 3 weeks of July, the business is trending well in residential, and parenthetically, I'd say also in Commercial and Refrigeration.

So we're off to a nice start.

You're still 2.5 -- 2.25 months left in the quarter, but we're off to a nice start in July.

And then in the weather comps in fourth quarter, actually, swing back our way as we had a warm fourth quarter last year that had created some headwind on a normalized basis for our Residential -- on a year-over-year basis for our Residential business.

So we remain cautiously optimistic for the balance of the year, and reflected that on the raise of our guidance.

Okay.

And then just the raw materials, is that -- did that higher raw material hit you in the second quarter or is that really more back half weighted for the year?

Yes.

It's a little bit of second quarter, but it's mainly back half loaded, and it's primarily steel -- or better stated, exclusively steel.

Okay.

And then just in terms of the mix of the portfolio, now that 14 SEER has anniversaried, is there any way you can kind of give us some of the high-efficiency type shipments versus minimum efficiencies within the Resi business?

What we'll do, Tim, is we'll start doing that again second half of the year.

There's still some messiness this quarter.

But starting at third quarter, we'll start going back to the old updates on talking about above minimum efficiency.

Our next question is from Gautam Khanna with Cowen & Company.

Just wondered if you could first talk about where you think we are in the Resi replacement cycle, what the duration of it is?

Obviously, it's been very strong.

And maybe comment on your thoughts on pent-up demand in the light as you move forward.

Yes.

I mean, I think spoken about this in the past.

I'll touch it again.

I think there's multiple drivers of demand for our business.

One, the first one has been over the last 3 or 4 years we think pent-up demand has been released from people who repaired units during the financial crisis over 2- or 3-year period, and those units rebreaking and coming back in to be repaired.

And I think that's helped drive the business over the last few years on the replacement side.

But increasingly, the driver of the replacement markets is going to be the housing bubble of the early and mid-2000s are now aging and becoming replacement units, and that's -- we think is going to drive the replacement market over the next 3 to 5 years.

And then on top of that, which isn't replacement markets, new construction-- the momentum in new construction continues.

We had a very good quarter, but single-family homes are still -- starts are still down below what a normal take-up rate is, given the household formation in the United States, and the millennials are now aging and getting in a position of being prepared to buy homes.

And so we feel pretty confident on residential new construction over the next 3 to 5 years also.

So we think it's a market that's going to grow mid-single digits over the midterm, which is 3 to 5 years.

Okay.

And just a quick follow-up on the prior question on commodity costs.

It seems increasingly likely that the Section 323 -- 232 tariff goes ahead, would you consider buffering more inventory, i.e.

just some advanced buys to kind of -- or are you just going to reset the pricing as soon as you face that headwind?

I think a couple of things.

I think the short answer is that we're going to have to drive it with price and/or other cost containment actions.

And I think the longer answer is if we could buy a warehouse full of cheap steel today, we would.

But our suppliers understand what's going on also, and are -- we have agreements with them and are honoring their agreements, but they're not allowing us to stock up warehouses with low-cost steel.

Next we'll go to Steve Tusa with JPMorgan.

The -- how big was the warranty help in Resi?

And then can you just give us a little more color on what product quality adjustment means?

Yes, the residential adjustment impact to resi was a couple million for the quarter, but what the adjustment was for Resi, making sure I get the right page here in front of me, make sure I sort of read this directly.

It -- we had a defective vendor supplier component.

And you saw the charge of $3.4 million after tax.

That effect has been isolated, the vendor is supplying corrected components, and reinstalling the corrected components.

The after tax charge relates to the total estimated repair cost of both labor and the product itself.

And we're working, i.e., negotiating with the vendor for recovery of our total expenses, and we'll see that in future quarters as we finalize the agreement with the supplier.

This has been something, I think there's been other items like this in the last couple of years that have been stripped out and added back, I mean, in kind of like different -- it's not always an expense.

Is there -- why would something like this be labeled, maybe I should ask this like 2 years ago when you did it, but why would something like this be labeled as a subtraction to the adjusted number there?

Sometimes, are you guys getting like payments?

Like did you record in a positive way like reversals, if you will, of a reserve?

I mean, the reversals, wherever we take the charge, we take the reversal.

So if we put a charge below the line, and as I suggest that we're going to get reversals for, we'll take that below the line too.

So we're trying to bleed that one way or another.

I mean, our -- again, we can talk -- we're being completely transparent, so it's all in our disclosures, and by the way, the gross margin number included it because gross margin's a GAAP number.

So we're not try to play games.

We're trying to make everything transparent, and we just think sometimes it's easier for analysts to track the numbers if the core number doesn't have things like the tax benefit from incentive compensation and sort of one-off things, but we're not trying to hide anything.

It's all there.

Yes.

No, no, I'm absolutely positively not saying that.

I respect you, guys a lot.

I think you do business in a very high-quality way, so definitely not trying to infer that.

Just trying to get details on the numbers.

I think you guys were also supplying -- Goodman had some issues on some coils, and they were sourcing them from you guys.

Is that true, and is that kind of played through already?

Yes, I'm not familiar with that.

I maybe not be familiar we supply coils to Goodman.

Out of our ADP business, we supply coils to distribution, so maybe some company-owned distribution, we sell some ADP coils, but I'm not aware of any quality problem.

Okay, got it.

And then just one more question on this commodity follow-up.

So have you already seen the adjustment in these prices for this tariff or whatever is coming in?

And ultimately, how does this -- if you kind of snap the line or even think of where, what your forecast is now because you've adjusted, obviously, it up by $10 million on steel, how does this kind of play through into -- in the next year?

Let me unbundle it a little bit, Steve.

I mean, the $20 million is what we see now, looking forward, on spot pricing.

And steel is the thing that we've come to the conclusion that the current spots or future spots or the futures on the steels are sort of the right number to use, and so I don't know how much of future tariffs are baked in the futures or not.

So I guess, I'm signaling if steel goes up more, then we'll have to adjust more.

We're hitting on the price that we said we are going to get for the year, which is $20 million.

The issue is just commodity costs have gone up more.

As we think about 2008 and obviously, in December, we'll give more guidance in all this, but where steel and copper, aluminum are as of today, it's clearly going to be a headwind next year, and quite frankly, a greater headwind than what we've had this year.

And we'll offset it with price and take appropriate cost containment actions as needed, but we're committed on the mid-term -- or the long-term guidance we gave of incremental drop-through to 30%, and we'll adjust our cost structure and/or price to make sure that's the case.

Next, we'll go to Jeff Hammond with KeyBanc.

Just on Commercial HVAC, can you just talk about how you think mix and price cost play out versus some of the issues?

And then it just sounds like -- and maybe clarify it, it sounds like, really, the issue was timing in new construction, and that's normalizes in the second half.

Yes, I think you sort of captured it, as we went to the details because replacement was relatively strong.

The issue was new construction.

Our new construction was up mid-teens.

First quarter was down; mid-teens, second quarter, in part, driven by new construction can be very lumpy and the weather.

We had warm weather first quarter, which sort of pulled forward maybe a little bit of demand.

Then we had some rainy weather in second quarter, especially in the Southeast that maybe pushed out a little bit demand, and then the other issue on margins was the national accounts that we did sell.

Some of the -- we had some large customers, especially in second quarter, who -- the product they buy was lower tier than some of our other customers, and it's such a lumpy business that can skew the margins.

But like I said in the script, as we look to second quarter -- or excuse me, second half of the year, we continue the forecast, and expect our commercial business margins and revenue will be up from last year's second half.

Good.

Todd, you guys have been share gainers here for some time, great momentum there.

Are you seeing any impacts from your competitors who might be share losers in terms of how they're going to market with price?

Any kind of price degradation or price wars creeping in?

Is that a commercial question or broader HVAC question?

I would say, you guys seem to have been successful in the emergency replacement and residential.

Yes.

On emergency replacement, we don't see price wars.

What we see is some other players getting involved in the market, where other competitors, other than Carrier and obviously now are on emergency replacement.

But we still continue to gain.

I mean, they are sort of down, softness in commercial, margins and revenue being up -- only up 3%.

Emergency replacement wasn't a driver of that.

It was sort of other verticals that I spoke about.

In terms of residential, no.

I mean, I think you saw we had a very good quarter in residential.

I think it will look like we've gained -- look like because it's true that we've gained share first half of the year.

Margins remain strong, up 140 basis points, and so, as I've often said at the edges of the empire, there's always skirmishes on price, but it doesn't appear to be any wholesale competitor decisions to compete with price in resi.

Next, we'll go to Robert Barry with Susquehanna.

I wanted to ask about price mix in Resi.

I think you said it was up 1, given all that RNC strength was probably a mixed headwind.

And I think you actually had a tough 2-year stack on mix.

So is there actually some pretty good price embedded in there?

I think there's price.

I also think there's -- in fact, I know what it is.

It's a strong mix up in the product categories.

We were asked earlier about giving a little bit more clarity to the portion of the product that's above minimum efficiency, and we want to wait till third quarter to do that.

But within our product line residential product line in second quarter, we saw a nice mix up year-over-year in the add-on replacement to more premium product, and that helped drive the margins.

Is that annualizing the reg change in the South or is it more than that?

I think it's above and beyond that because, really, where we saw the mix was less of going from 13 to 14 SEER in the South, much more of going from 14 SEER to 15, 18 SEER across the country.

I see.

And all that strength in RNC, I mean, there has been some concern about pricing in general, like rising price pressure in Resi.

I think you've commented in the past that it's a little bit more concentrated there.

I mean, is pricing a factor there?

It just seems like really strong, especially given, I think, starts and completes were up high single in the quarter.

I think it reflects the strength of our company owned distribution model that with the national builders, and to a lesser degree regional builders, we're able to handle large swaths of geography and provide the same service and support in national pricing.

So there's not intermediaries that you have to deal with, but I don't -- I think the short answer is what I said earlier to Jeff that the pricing impact, whether it's add-on replacement or residential new construction, it's no different than it's been the last few years.

Got you.

And maybe just lastly on Refrigeration margins, I think, first half, you're up about 140.

So to get into your range imply second half is about flattish.

Is that how we should be thinking about Refrigeration margins?

I think that's how I'd build it.

Maybe we do a little bit better like we did last year, but that's how I'd encourage you to build the model.

Next, we'll go to Julian Mitchell with Credit Suisse.

Just my first question is really on the gross margin.

That had been up 90 bps year-on-year in the first quarter, was sort of flat in the second quarter.

Am I right in thinking that was about, if I'm looking at that delta year-on-year, you had maybe 50 bps loss from the product adjustment cost, and then maybe the balance was material costs' headwind?

Just if you could comment on why the gross margin was flat?

And also do you expect the gross margin to grow again year-on-year in Q3?

I won't comment directly on Q3.

I'd comment on second half of year.

And yes, we expect gross margins to be up second half of the year.

You did the math exactly on the note that I have in front of me.

The special product charge costs us about 50 basis points on the gross margin.

And then there's lots of other puts and takes, but I think you're probably right to sort of grab on, especially in commercial, the price commodity gap that I spoke about was also a driver of the gross margins being flat, but the major one is we have been up 50 points without the special product charge.

Understood.

And then Residential, obviously, a very, very strong second quarter.

You've got very good line of sight on the distribution and the state of inventories.

Just wondered how you feel about Residential inventory levels today in the channel both for your own product?

And of course, if you think there's anything awry or anomalous in the broader Resi HVAC industry in terms of current inventory levels in the U.S.?

Yes, I mean -- and again, I know you know all these, Julian.

But one, I don't know what the competitor distribution channels look like with their independent.

Ours is 80% company-owned, and with our Lennox distribution, we see the revenue when it leaves our distribution.

And so we really don't have good line of sight.

I mean, in our Residential business, we know about 10 days out what the revenue demand's going to be, and so we can track order rates.

In our Allied business, which is the 20% at the sellthrough independent distribution, inventories -- our sense is sort of at the right position.

Our independent distributors have seen our ability to meet at-once demand, and our flexibility around delivering and distributing the product out of our North American factories.

And so quite frankly, they carry less inventory than they used to and rely on us to support them, and we're in position to do that.

And last very quick one, commercial margins, they were down, I think, 50 to 60 bps year-on-year in the first half, the second half growing again.

So should we think the year is about flat for commercial margins?

Yes.

That's how I would model it.

Our next question is from Ryan Merkel with William Blair.

Just sticking with second half margin improvement in Commercial.

Todd, are you expecting both better mix and to be getting some price to be the driver there?

Short answer is yes, and then longer answer is we're also taking cost containment actions to make sure that we help protect the margins.

I see.

Can you quantify the cost containment just to help us out or...

No, not yet.

I mean, it continues to be things that we're doing on the factory and around discretionary spending, and we continue to -- we'll talk about that more in the third call -- third quarter call exactly what we're doing.

But we understand we need to get our margin growth back on track in Commercial, and we're committed to doing that.

Okay.

And then I wanted to ask the Amazon risk to HVAC.

As you probably know, there's Goodman equipment available on Amazon through a reseller.

I'm now getting e-mails from Amazon about home services and my HVAC needs.

So maybe just to explain what the barriers are and then why might HVAC be harder for Amazon to disrupt than general appliances?

I think the high-level answer is because it's an Applied product, and that you rely on the dealer to install it, and we internally -- well, I think everyone understands half the cost of the -- or half the cost for the unit is the installation.

Half is the equipment.

And then we always talk internally about 80% of the quality is the installation, and 20% of the quality is the actual design and manufacturing of the product.

And so I have no doubt Amazon can find dealers to install equipment and match them up with Goodman equipment, but the question is, who are the dealers?

What training do they have?

Do they have LennoxPROs that allows them to when they go in, watch a video on how to install it, have they gone through all the training classes and support that we provide them.

So I think it's very difficult for them to disrupt, not impossible, but it's not the same as buying a washer or a dryer because you have this huge installation.

And we continue to talk internally about all the things we have to do to make our dealers sell much better than what you can get with ABC cooling that's matched up with Amazon online.

So I would tell my mother not to buy a Goodman air-conditioner from Amazon's dealer that no one knows who it is.

That's if she wants it to work.

Well, plus you'd have to wait 4 to 7 days to get it.

Yes, fair enough.

And we'll go to Jeffrey Sprague with Vertical Research.

Lots of ground covered here.

Maybe just a few other items.

This wild swing in the peso this year, any disruption to kind of your cost and sourcing estimates for the year related to that?

No.

I mean, we have some headwind in second quarter that we didn't talk about, but order of magnitude is $1 million or $2 million on the cost side that we absorbed it, and offset it other ways, but we still really like our Mexican factory even with the swing in peso.

And then on steel, I was wondering if you could give us just a little bit more of a frame of reference.

Obviously, we don't know what your buy is at for 2017, and I don't expect you to tell us precisely.

But if you're looking at kind of where you're at in '17 versus where spot stands today, spot is the good indication of where we're headed.

Can you give us a sense of kind of order of magnitude of pressure that's visible for next year or how you'd frame that looking into next year?

I mean, I think I'd just talk about how we buy, where we buy based on the prior quarter CRU at a negotiated discount that we have with the mills.

And then it takes another month or 2 to work its way through our inventory to be able to see the costs, and so I would -- if I was building a model, I would tend to think about what steel pricing has moved on the spot based on 5 or 6 months prior period.

And then I think you can sort of get the percentage move of the steel as opposed to our COGS.

Okay.

That's helpful.

And then just on Refrigeration in North America, specifically, I wonder if you could give us an update on what's going on with your customer set and what you might be working on when we think about Amazon's initiative and the German new entrants, where you're at relative to those opportunities or challenges.

I mean, we -- our portion of our business that sells into grocery, the largest part of that is our Kysor/Warren business display case business, and as we spoken about, we continue to focus on diversifying our customer base.

I'll be honest with you, I mean, The Amazon thing is, it's really Whole Foods at the current point and we call on them.

We don't do a whole lot of business with them right now, but it's clearly someone we knock on the doors.

The majority though of our Refrigeration business in North America is our traditional heat product group business or HRP, as we call it internally.

And we continue to grow that business where we have significant buildout -- or North America is having significant buildout in cold storage because regardless of what storefront it goes through, it has to have these intermediary locations that holds to prepare the frozen food, and we're very good at that segment.

So our Refrigeration business in North America was up all-in, in second quarter and that continues to be a strong business for us.

Next we'll go to Rich Kwas with Wells Fargo Securities.

Just a couple of quick ones.

So just back on the product issue with the vendor, was that stuff shipped in the last couple of quarters?

Or does it have the longer tail to that?

It was shipped in the last couple of quarters.

Okay.

All right.

And then on price...

I'm just looking.

I'll make sure I got that right.

I'm looking at Joe, yes.

Okay, go ahead.

Yes, on the -- in the field, it seems like Residential price stickiness, at least, relative to expectation is pretty good.

So you mentioned Commercial as being a little bit of a lag.

How about Refrigeration, was there any negative impact on the quarter on price versus expectation kind of limiting your ability to get price traction overall?

No.

Okay.

So it's on Commercial.

Yes.

And is Resi in your view better than expected on a price standpoint?

No.

I'd say it's as expected.

I mean, our guide coming into the year was $20 million in price, and that's still the guide.

Quite frankly, I don't know if surprise is the right word, but certainly, the change in the guide has been commodities going up, not our ability to get price.

Getting price is roughly what we thought.

Okay.

And then on schools, how are you seeing schools balance of the year?

I know that's pretty important.

And then just broadly, retail, I know it's been touch on a little bit, but was it -- when you look at the activity with new construction and whatnot, just purely timing, not -- nothing in the market that warrants any concern on your end?

No.

I mean, first, on schools, we were up mid/high single digits in the quarter, and we were very good at schools.

We have focused channel.

Our sales channel focused on and have the right product, and also our VRF plays strong there and as a driver of our VRF sales.

And your second question was on new construction in commercial?

Yes.

As it relates to -- I know you talked about timing, Todd, around first grade.

When it relates to timing, yes, I read your notes when you've published all the architectural information and sort of the leading indicators.

Nothing's changed.

I think it's just the chunkiness of our business.

I wouldn't read any macro driver into what happened.

I think it's just timing in individual customers.

The next question is from the line of Josh Pokrzywinski with Wolfe Research.

Just maybe to come back on underlying comments earlier, hopefully, you're not trying to get your mom to buy any Goodman equipment, regardless of the channel.

Maybe we need to get that in the proxy somewhere.

I like -- my dad does teardowns for me.

So I sometimes like him to buy competitor equipment just to look at it.

Fair enough.

I guess, going back to the price thing on Residential, I mean, I think you've made this comment of telling you the border skirmishes for a while.

The chatter at least has heated up.

Maybe to compare your comments earlier on how its price trended this year, do you think the industry needs to go for an off-cycle price increase?

Or are we setting ourselves up for when some of these -- these hedges roll or spot rates normalize early in 2018 that the amount of price that everyone is going to need to get collectively all in one slug is maybe a bit too big for the channel to want to take down or maybe start to see a bit more pushback than normal?

I think people can see what's coming, and it's -- even where we're at now, it's not going to be like it was in 2011 when commodities went up $40 million, $50 million.

So I think the short answer is we'll -- I don't think we're going to get a mid-season price increase.

I think we're at where we're at, and again, it's sort of hard to say we publicly talk about things, but it's hard to -- we're offsetting commodities with price.

We're just not doing better than commodities with price, and as we roll into 2018, as I mentioned earlier, we'll sort of measure where we're at.

We'll raise price to offset it, and we'll also quite frankly adjust the cost structure, and have other cost containments to make sure we protect our margins.

And then just a follow-up more of a modeling nuance, so we don't have an issue as we lap some of these quarters with the extra week along the way.

Is there anything from a margin perspective we should keep in mind?

I think it's easier to see it in the top line than maybe it is in the cost structure.

Anything, Joe, that we should keep in mind in that regard?

No, I don't think there's any anomalies other than what we mentioned with just the different days that we adjust in first and fourth quarter.

But outside of that and updating the steel guidance for second half, I think that's all I would suggest.

Okay.

So everything continues to drop through kind of this again 30% target incremental if all goes well?

I think high -- -- yes, absolutely plus or minus.

And then I think on the decremental days that we have in fourth quarter, I would think about that volume dropping through to more standard rate of 25%.

I mean, the 23% incrementals refer to sort of all the things we do on cost reduction and others, and then the decremental on the fewer days, I would think about that dropping through at 25%.

Next, we'll go to Robert McCarthy with Stifel.

Obviously, a lot of ground covered here today.

I mean, could you talk a little bit about the cadence, if you could?

Just April, May, June in terms of what you saw?

And what is that pre-stage for kind of third quarter from your standpoint in terms of what you saw?

Obviously, visibility is limited.

Yes, April, May and June in Residential, all 3 were strong.

And there was, quite frankly, some concern as we went into June.

I publicly have said April and May were up double digits.

And there were some, not concern, but we could read the weather map and we knew how hot it was last year going into June.

But June, again, turned out to be a strong month for us.

So across the board, it was strong.

In Commercial and Refrigeration, especially -- most specifically on Commercial, as I talked about new construction being down, that was in part driven by June, and some of the wet weather we had.

And so June was a little soft on deliveries as things got pushed out, but the flip side of that is we entered the quarter with strong backlog and strong order rates.

And I used the word nice to talk about how Q3 is shaping up for commercial in July.

And so I'm trying to underline.

Look, I get we had some softness in Commercial in second quarter, but we feel pretty good about the business, moving forward.

Understood.

I mean, a longer-term question, and frankly won't be about the industrial Internet of Things, your favorite topic.

I guess, talking about conceptually, your supply base in terms of some of your key components, whether it be compressors or motors, do you think there's just an opportunity here to do more value-based engineering, get better sources of supply, get better margins structurally over the next couple of years just given the changing landscape of who you can choose in terms of suppliers and vendors?

Yes.

I mean, I think that's been an important part of our material cost reduction in the last few years, and I think it certainly continues.

And so we're aggressively focused on whether it's designing, making a change of the type of material that we use, aluminum rather than copper or taking costs out of our product by working with Asian suppliers or redesigning how the systems interact by using software.

And so we're clearly focused on that, and quite frankly, spending a lot of resources on it both in the U.S., India and our China technology centers.

And so yes, we're absolutely focused on that.

And then the last question is just on any thoughts in terms of the strategic environment for M&A?

And any areas of -- obviously, in the past, you talked about opportunities in Refrigeration and diversification there and growth.

I mean, how would you typify the M&A environment from your perspective right now?

Well, I think we're pretty focused right now.

I mean, if there was a large or better -- if there was a deal that we could consolidate the North America HVAC business and the North America unitary rooftop and/or Residential, we would certainly want to play there.

There might be something in Europe with our European HVAC business to get some more oomph there that we would do, and then maybe something in Refrigeration.

But I still think we have a ways to go in Refrigeration organically driving up margins before we'd want to do another deal there.

And we'll go to the line of Chris Belfiore with UBS.

In Refrigeration, could you provide some color on the weakness in Europe?

Was it just the mid-teen comp from last year or was there something more structural?

Yes, it was just -- it was that.

There was lumpiness in customers.

I mean, our HVAC business was up by about the same percentage as our Refrigeration business was down.

It's just the timing of customers and to your point, a challenging comp.

Okay.

And then just in terms of CapEx, how does that spend break down between maintenance versus growth/investments?

And how should we think about free cash flow conversion into next year and beyond?

Yes.

I think starting with the CapEx, maintenance is about 10% to 15% of the total spend.

And then free cash flow conversion, we'll continue to target free cash flow to approximate spend income.

So I think we'd be somewhere between 90% to 95%, prospectively, on that conversion rate.

Our next question is from Walter Liptak with Seaport Global.

My good questions were taken.

I was kind of late in the call.

So I guess, I'll ask about this for third quarter and just the timing.

I think July was really strong last year, and then we kind of went through the seasonal downturn -- or slowdown, I guess.

And then maybe if you could comment on how those comps look for you this year.

And then now it seems like new build was stronger maybe than last year.

What was replacement like in the third quarter last year?

Yes, I mean, the comps on resi, third quarter was warm last year and fourth quarter was also warm.

So third quarter warmth was goodness last year and fourth quarter warmth was badness, as it hurt our furnace season in November and December.

I've sort of said a couple of times that we're off to a nice start in third quarter, which means our Resi business is doing well.

It's actually been warm in many parts of the country through the first 3 weeks of July, so I have visibility for the whole month.

And so we're going to have a nice July in residential and in our other businesses, and so that's going to come down to August and September.

But if people were worried about the weather comps in July, they shouldn't be because we've gotten almost to the other side of July, and we're tracking nicely.

Okay.

Was new build strong last year or we're seeing a better new build market for Resi this year?

Yes.

We had strengths last year, but I -- from memory, I think we're up 10% or so last year in new construction.

And obviously, given what we performed here in second quarter, we're up year-over-year through the first half of the year in new construction.

With no further questions in queue, I'll turn it back to the presenters for any closing comments.

A few points to leave everybody with.

The company had strong growth in the second quarter, set new all-times highs -- set all -- set new all-time highs for revenue and profit.

The third quarter is off to a nice start, and we look forward to continued momentum in the second half for a year of record revenue and profit for Lennox International.

Thanks to everyone for joining us today and have a good day.

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

Thank you for your participation.

You may now disconnect.