Lennox International Inc (LII) 2017 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

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

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

And 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 2017.

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.

(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 a direct link to the webcast to today's conference call on our website at www.lennoxinternational.com.

The webcast will be archived on that site for replay.

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

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

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

The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events 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 13 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 thank you for joining us.

Lennox International posted a record third quarter for revenue, total segment profit and EPS.

But it was also a quarter where growth and margin performance were materially impacted by significantly-cooler weather than a year ago and by the hurricanes that hit Texas and Florida.

Nationally, cooling degree days were down every month in the quarter, including more than 20% in both August and September.

Overall for the third quarter, cooling degree days were down 16% from the prior year, and the key swing regions of the upper Midwest and the Northeast were down more than 30%.

The hurricanes caused near-term market disruption in the 2 largest HVAC markets in North America, with not much business taking place for a couple of weeks or so in the regions that were hit.

These dynamics most directly impacted our residential replacement, commercial emergency replacement and refrigeration wholesale businesses to weigh down our growth and margin performance for the quarter.

Overall for the company, revenue was a third quarter record $1.05 billion, up 3% at constant currency.

On a GAAP basis, operating income was down 1% to $155 million.

GAAP EPS from continuing operations is up 5% to a third quarter record $2.45.

On an adjusted -- in adjusted basis, total segment profit rose 2% to a third quarter record of $161 million.

Total segment margin was 15.3%, up 30 basis points from the record third quarter level a year ago.

Adjusted EPS from continuing operations rose 9% to a third quarter $2 -- third quarter record $2.53.

Turning to the key points on our business segments for the third quarter.

In residential, revenue and profit hit new third quarter highs.

Revenue was up 3% on high-single-digit growth in new construction and low-single-digit growth in replacement business.

Segment margin was 19.4%, up 30 basis points from the record third quarter level of a year ago.

Residential profit rose 2%.

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

We ended the quarter with a total of 230 Lennox PartsPlus stores, up 14 stores in the quarter.

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

In manufacturing, we're on track to realize $6 million of savings this year in our Mexico operation, and we expect a similar level of incremental savings as we look ahead to 2018 from productivity initiatives in our U.S. operations.

Turning to our commercial business.

Revenue and profit hit new high marks for any quarter.

Commercial revenue was up 6% at constant currency.

Segment margin was 18.6%, up 90 basis points from the record quarter a year ago.

Commercial profit was up 2%.

The commercial margin decline in the quarter was impacted by 2 factors: First, we had large orders from certain national account customers that were a lower product mix that shipped in the quarter.

And the second factor was the year-over-year change in the timing of some expenses.

Price and commodities were balanced in the quarter.

We continue to expect commercial segment margin to be slightly up in the second half in total over the prior year period.

Looking at commercial revenue drivers in the third quarter at constant currency, North America equipment revenue was up high single digits.

Replacement revenue was up low double digits; the planned replacement revenue, up 20%; and emergency replacement, approximately flat.

New construction revenue was up mid-single digits.

Cutting the business another way, national account equipment revenue was up nearly 20%, and non-national account revenue was up low single digits.

Looking at new national account equipment business.

Lennox won 11 new customers in the third quarter for a total of 37 year-to-date.

New customers in the third quarter included health care, facilities, restaurants, retailers and construction and real estate firms.

On the National Account Service side of the business, revenue was up mid-teens in the second quarter.

In Europe, commercial HVAC revenue was down low double digits at constant currency.

In Refrigeration, revenue was up 2% at constant currency.

From a regional perspective at constant currency, North America and Australia were flat; South America was up low single digits; Europe was up low double digits; and Asia was up more than 25%.

Refrigeration margin was down 190 basis points to 10.4%, and segment profit declined 13%.

The margin decline was driven by a negative mix from the weather impacts on our North America business, which is our most profitable business.

We also had productivity issues in several of our key factories.

We are addressing this and are well on the way to having these behind us.

As you've seen on our October 5 announcement, we have new leadership for our Refrigeration business in place, with Gary Bedard taking over as President and Chief Operating Officer.

Many of you know Gary, who's done an outstanding job over 2 decades at the company, including the last 10 years as Vice President and General Manager of our highly successful Lennox residential business.

A few moving pieces in the third quarter, but Lennox is well positioned to close out the year of record revenue, margin and profit in 2017 and to drive strong growth and profitability over the coming year.

Now I'll turn it over to Joe.

Thank you, Todd.

Good morning, everyone.

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

Residential revenue was a third quarter record $591 million, up 3%.

Volume was up 3%.

Price and mix combined was flat; with price, up 1% and mix, down 1%.

Foreign exchange was neutral to revenue.

Residential profit was a third quarter record $115 million, up 2%.

Segment margin was down 30 basis points to 19.4%.

Segment profit was positively impacted by higher volume, favorable price, sourcing and engineering-led cost reductions and foreign exchange.

Offsets included higher commodity and other product costs; unfavorable mix; investments in research and development, information technology and other SG&A; as well as investments in distribution expansion.

Now turning to our Commercial Heating & Cooling business.

Commercial revenue was a record $269 million, up 7%.

Volume was up 5%.

Price and mix combined was up 1%; with price up and mix flat.

Foreign exchange had a positive 1% impact.

Commercial segment profit was a record $50 million, up 2%.

Segment profit margin was 18.6%, down 90 basis points.

Segment profit was positively impacted by higher volume, favorable price, sourcing and engineering-led cost reductions, lower SG&A expense and favorable foreign exchange.

Offsets included lower mix, higher commodity costs, higher freight and distribution expenses and the timing of other expenses.

In Refrigeration, revenue in the third quarter was $192 million, up 3%.

Volume was up 2%, and price and mix combined was flat.

Foreign exchange had a positive 1% impact on revenue.

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

On a reported basis, North America was flat.

South America and Australia were both up mid-single digits.

Europe was up mid-teens, and Asia was up more than 25%.

Refrigeration segment profit was $20 million, down 13%.

Segment margin was 10.4%, down 190 basis points.

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

Partial offsets included volume and sourcing and engineering-led cost reductions.

Overall for the company on an adjusted basis, the third quarter excludes net after-tax charges of $2.9 million, including $1.3 million of special legal contingency charges; $1.1 million of restructuring charges; $1 million for asbestos-related litigation; and a total of $1 million for other items.

Also excluded was a benefit of $1.5 million for excess tax benefits from share-based compensation.

Corporate expenses were down 13% in the third quarter to $24 million.

Overall, SG&A was $159 million in the third quarter or 15.1% of sales compared to 15.5% in the prior year quarter.

Cash from operations in the third quarter was $177 million, up from $152 million in the third quarter a year ago.

Capital spending was $17 million compared to $18 million in the prior year quarter.

Free cash flow was $160 million, up from approximately $134 million in the third quarter last year.

Total debt was $1.12 billion at the end of the quarter.

And we ended September with a debt-to-EBITDA ratio of 2.0.

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

Before I turn it over to Q&A, I'll review our outlook for 2017 and provide a few thoughts on 2018.

For the industry overall, we expect North American residential HVAC shipments to be up at the lower end of the mid-single-digit range.

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 market environment, the company's performance year-to-date and outlook for the fourth quarter, we are raising the low end of our revenue guidance from 4% to 7% with neutral foreign exchange to a new range of 5% to 7% with a 0.5 point benefit from foreign exchange.

For GAAP EPS from continuing operations for the full year, we are updating our guidance from a range of $7.73 to $8.13 to a new range of $7.67 to $7.97.

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

We are updating guidance for adjusted EPS from continuing operations from a range of $7.75 to $8.15 to a new range of $7.75 to $8.05.

Now let me run through the key points of guidance assumptions and the puts and takes for 2017.

First, on the guidance points that are changing.

We now expect a $5 million benefit from foreign exchange for 2017 versus our prior guidance for a neutral impact.

We now expect residential mix to be flat this year instead of a $5 million benefit given the faster growth in residential new construction than the replacement business.

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 are on track for $6 million in savings from our manufacturing operations in Mexico from actions already taken.

We continue to expect $20 million of headwind from higher commodity costs this year, offset by $20 million of price this year.

As an aside, looking ahead for next year 2018, we continue to expect approximately $40 million of headwind from higher commodity costs, offset by $40 million of price, so similar to a year -- of 2011 in that regard.

Now back to 2017 for a few of the guidance points that remain unchanged.

We continue to expect an effective tax rate between 31% to 32% on an adjusted basis for the full year.

Corporate expense is still expected to be approximately $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.

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) Our first question comes from the line of Tim Wojs of Baird.

I guess, maybe just the first question I have is, if you could tease out maybe the mix impact on margins in residential for the quarter?

And then I know this is kind of a pretty tough question, but what do you think the hurricane might have cost you in the third quarter?

Again, the -- our margin, being down 30 basis points in the quarter for res, was driven by the mix.

And the higher-margin replacement -- the math I would look at was the higher-margin replacement business was only up 2% in Q3, while our new construction business was up high single digits.

And as we discussed, the replacement growth was really tampered down by the cool weather in Q3.

So I'm not going to give you the exact math but -- because it's sort of hard to, quite frankly, to understand with the moving pieces, but it's clear that the reason the margins were down was we mixed down because we sold less add-on and replacement and more new construction.

Within our add-on and replacement business, we continue to mix up, so we're selling more premium product than we did the prior year.

In terms of the impact of the hurricanes, I'll be honest with you, Tim, we've had a lot of conversation about this internally.

It's really hard to quantify.

There's lots of moving pieces.

But I think one point that I would point to is that our residential replacement business, over the last 6 quarters, has, on average, grown about 8% year-over-year.

In Q3, the replacement business was only up 2%, and there was no change except cooler weather and the hurricanes.

And so I think that's sort of an order of magnitude of what we were impacted, either by cooler weather, by the hurricanes, and we'll see some of that bounce back in future quarters.

Okay.

Okay.

And then just on '18, just a commentary on the inflation cost and pricing.

That's -- it's a bigger hurdle from an incremental margin perspective.

So just given that you have a 30% incremental margin, I guess, target on an intermediate basis, what are some of the other things outside of sourcing, maybe some of the productivity within North America, that can help you get back to that 30% incremental margin in '18?

Maybe I'll walk through the sort of -- a preliminary bridge, if you will, from '17 to '18.

And again, as you note, Tim, we'll be providing detailed guidance on 2008 (sic) [2018] on our annual Analyst Day in mid-December.

But a couple of points I'd make is our end markets have been growing at low to mid-single digit range.

While there's always risk as we saw in Q3 from weather, we don't see much of that changing as we go into '18.

We think the momentum continues for all the reasons you've heard us talking about.

In addition, we continue to gain share in this year in our HVAC business in North America.

We're about a -- up a little over 0.5 point in market share, and that's where we've been the last 4, 5 years.

I think that continues.

We're focused, as you suggested, on a 30% incremental, and we're committed to doing that next year.

And sort of the moving pieces to me are, we expect another $30 million to $40 million of incremental savings from sourcing and engineering-led cost reduction.

We've talked about, while we're not getting Mexico savings next year, we're confident we can get similar $5 million to $10 million of savings from productivity initiatives in our U.S. factories, both by automation and other lean techniques.

As you talked about, for commodities, we expect about a $40 million headwind.

The phrase I've used before is about twice of what we had this year, so it's plus or minus $40 million.

We're confident we're going to be able to offset that with, order of magnitude, $40 million of price.

I think sort of the newer story from the last couple of years, and I've talked about this publicly the last few months, is we're targeting SG&A productivity.

And over the last few years, as we've had a windfall both of commodities and price, we've been able to accelerate SG&A spending in IT and R&D on some big strategic investments.

We've had SG&A as a percent grow in line with revenue growth rate percentages.

And while we think in 2018 that it will grow more in line with half or maybe even 1/3 of the revenue growth.

And so while we're still going to continue to invest in SG&A, the growth rate will slow down.

And we think that helps -- the SG&A productivity that we'll get will help ensure that we'll be able to get to 30% incrementals.

So overall economic conditions remain solid now as we into '18.

And we expect another record year, and we're targeting 30% incrementals.

Your next question comes from Gautam Khanna of Cowen and Company.

Todd, I was wondering if you could expand upon how you're trying to grow same-store sales at the PartsPlus businesses?

What specifically are you doing to kind of accelerate growth at some of your more mature stores?

We'll talk about it more when we -- at the December Analyst Day.

But sort of high-level, I think about it this way.

We put -- the name, historically, has been a bit of a misnomer.

They're called PartsPlus, but they were really put in place with the focus of growing equipment sales.

And they've done a great job of doing that.

But we now have these mature stores in place.

And if you look at our mix of parts and supplies, so the revenue that we sell as a residential business, our parts and supplies mix is about 25% and the other 75% is equipment sales.

You look in a Watsco, sort of an industry-leading distributor, they're more 30%, maybe even 35% parts and supplies.

And so we think it's a big opportunity to grow our parts and supply business and flow it through this fixed-cost asset, these stores that we have.

And so we've taken aggressive initiative, and we'll share again some of the -- more of the details in December.

But focusing on targeting what SKUs we want to carry, i.e., broadening and deepening the parts and supplies that we carry, focus on the training of our counter people to make sure they're in a position, both because we've trained them but also that they have the sales tools and information to be able to sell parts and supplies.

And then the third piece is around inventory and logistics management to make sure we're inventorying the right parts and pieces on site to be able to meet demand.

So we think there's a big opportunity there.

Okay.

And one follow-up.

At Refrigeration, when do you anticipate some of the better economics on one of your large customer contracts will start to benefit your margins?

I'm specifically referring to Walmart, of course.

We continue to work through with the Walmart business.

We recently won -- and others, our competitors, won businesses on the display cases.

We're going through the quoting process with them on the system part of the business.

And longer term, our goal within our Kysor/Warren business is to grow the margins, not only from making the Walmart business more profitable, but quite frankly, diversifying our customer base.

We think we've done a pretty good job of taking costs out of the factory.

We continue to design costs so higher portion of material cost reduction as a percentage of revenue is coming out of KW than maybe any other business that we have.

But it's also focusing, quite frankly, on winning new customers, and our team's focused on doing that.

And next, we'll go to the line of Jeff Hammond of KeyBanc.

On Refrigeration, did you mention factory productivity issues?

Just what's going on there?

It seems like the margins have stepped back a little bit after some period of progress.

Yes, let me broaden the answer.

I mean, we saw margins down 190 basis points after being up the last 5 quarters or 6 quarters.

There are 2 major drivers.

And the first one's a primary one, which was negative mix from the weather impact on our North America businesses.

Our most profitable business in all of Refrigeration is our North America Heatcraft Refrigeration products group.

We call it HRP internally, which is the non-Kysor/Warren part of the business.

And more than 50% of that business is sold through distributors.

It's a flow business, sort of demand business that is tied to economic conditions, but also quite frankly, tied to weather and what's happening in the marketplace.

Our Heatcraft business over the last 6 quarters, on average, had a growth of about 4% per quarter.

And in Q3, we saw a 2% decline.

And while there were some other moving pieces on demand side, we think weather had a major impact.

So this very highly profitable business we have, being down 2% rather than being up 4% as it has over the last 6 quarters had an impact, so it mixed down.

And then the other is, yes, I did mention on the call that we had some productivity issue on several of our key factories in Europe, and one of our Heatcraft factories in North America.

We're addressing this, and we're well on our way to having those behind us.

The issues were material flow issues and labor productivity.

We continue to expect Refrigeration margins this year to be flat to up 50 basis points.

I think prior guide was 50 basis points.

We may think there'd be a little pressure on that, but we continue to focus on reaching the 12% to 14% segment margin by 2019.

As I mentioned, Gary Bedard is now Head of our Refrigeration business, and he's laser-like focused on some of these issues.

Great.

And just on Commercial Heating & Cooling.

The 20% growth in National Accounts, any positive lumpiness or timing there?

Or is that just some key wins?

And then I think you said emergency replacement was flat.

Is that kind of weather?

Or maybe a little color there.

Yes, we think emergency replacement was clearly weather because we've been up high single digits, close to 10% the last couple of years.

And so we think that's clearly weather-driven.

On the National Accounts, it's always a combination of both.

So last quarter, we had revenue that was slower growth than what we've had, and then this quarter we had strong growth.

So I think it's a combination both of sort of the lumpiness of National Accounts, but also we think continues to reflect -- and while we always talk about these accounts that we're winning because we continue to diversify our national account footprint, our customer base.

And while retail gets a lot of the headlines in the Journal, these other verticals that we're playing continues to grow as a percentage of our national account, and more broadly, our commercial business.

And next, we go to the line of Rich Kwas of Wells Fargo.

Hey, just on commodities, the $40 million for next year, what kind of lag impact does that have as we think about extending into '19?

So if you snap the quarter-to-date, does that fully get you up to speed with regards to the cost headwind?

Or I suspect, because there's smoothing the habits of the hedging, that there's some -- still some negative impact that creeps into '19.

But just kind of broad thoughts around that.

Quite frankly -- I mean, I'll give a narrow answer and then I can broaden it with some rambling comments you can help model yourself.

The short answer is I think it really depends what's happened second half of the year and sort of how quickly it moves.

So for -- as you know this, Rich, but for others on the call, that 65% to 70% of our COGS is material, and 25% to 30% of that are commodities.

And on steel, we buy on a prior quarter market pricing with a discount from the mills; and then copper and aluminum, we hedge about half of it to 12 months out.

And as we look at '18 on copper and aluminum, we're order of magnitude about 50% hedged already.

So as we look at '18, we're 50% hedged.

And so the flip side is, there's 50% on the spot market.

And then the other point I'd make, as you think about how to model the timing, is from the time we buy the steel to the time you see it flow through COGS, is probably another quarter because just of the timing of how it flows through the P&L.

So again, we think, order of magnitude, it's going to be $40 million next year, and that's betting a little bit on taking the future curves of what we think copper and aluminum is going to do second half of the year.

And it sort of depends how it moves second half, we'll have impact as we go into '19.

Okay.

And then in terms of the replacement versus new construction piece, do we, from a mix standpoint, just big picture, do we think about replacement incremental margins being north of 30% and new construction, incremental margins under 30%?

Is that -- like, if I were to say 25% for new construction, 35% for replacement, am I far off in terms of trying to gauge the mix impact here in this quarter?

No, you're close.

Okay.

Great.

And then last quick one, just start to October.

I mean, the first part of October was warmer than normal against year ago period; second week's been better.

So I mean, what have you seen so far?

I know it's early.

I know most of the heating season's yet to come, but just any quick thoughts.

Yes.

No, I mean, I think it's early, as you suggested, but we're off to a solid start.

And then as you said, and for others on the call who don't know our business as well, is we're now rooting for cool weather.

It needs to turn cool.

And so if -- we want it to get cool in the Northeast and Midwest.

December is always an important month.

A couple scorekeeping things to remember was, last year was a warmer-than-normal Q4, which led to a lower mix of furnaces.

So if weather is more normalized this year, that's going to be sort of a good tailwind for us.

The other housekeeping reminder is, while we had 6% more days in Q1, because of the calendar, we're going to have 6% fewer days in Q4.

And so all things being equal, we have sort of order of magnitude of 6% headwind on revenue.

Next, we go to the line of Jeff Sprague of Vertical Research.

Not to split hairs on price cost, but I think Joe explicitly said that price offset costs in commercial and didn't make a specific remark on resi.

Is resi caught up in the quarter on price?

In residential, just looking at my details, almost.

We're a little short on price, but again, I think that had to do with -- we were within $1 million or $2 million of offsetting commodities.

In prior quarters we had, we think that had as much to do with the mix of business and ability to get price with builders versus the flow business.

So -- where in Commercial, we were -- called out last quarter that there was a timing lag, and now in third quarter we caught up, I think in Residential, it's more reflecting the type of business mix that we had.

And do you have any view at all on just kind of post-hurricane dynamics?

Does stuff just get pushed to next season?

Or is there kind of a catch-up play here in AC, even though we're going off season?

Just how do you see that playing out?

Not totally sure, and that's why I'm being a little bit opaque on the guide.

Because, quite honestly, we're not sure internally.

So I mean, what we know operationally is we're getting lots of parts and supplies in market because we think a lot of people, given the financial impact to a lot of homeowners and certainly in Houston, that not a lot of people are going to be able to cover all this with insurance, that things may be Band-Aided initially.

And so we're making sure we have lots of parts and supplies there to be able to meet the demand.

Being longer term, people will need to replace units and that may be more in 2018 and maybe bleeding into 2019.

And again, we'll have equipment in market to be able to do it.

I think right now, in both these markets, we've seen some spike up in parts and supplies, not much movement in equipment yet.

But that's to be expected, because quite frankly, they're still sorting things out.

And then just finally on refr.

Todd, it's clear you're not happy with the performance, and you made some management changes there.

Is it kind of surprising to hear productivity issues at several plants, like in one quarter.

Is that kind of coincidental?

Or did something kind of inherently just go wrong in the way production is being scheduled or supply chain or something else?

I wouldn't say it's coincidental.

I also wouldn't sort of get hung up on a systemic issue.

When I look at the 180 -- 190 basis points movement in margin, the major driver we think was the mix of our North America business.

But I also wanted to be fully transparent that we did have issues.

And again, it has to do -- we have a very sophisticated engineered-to-order product line, both in the U.S. and Europe.

And we ran into some issues, and we're addressing them and putting them behind us.

Next, we have the line of Robert Barry of Susquehanna.

Just maybe to follow up on that last question, I think you noted Europe commercial was down quite a lot.

Is that related to the operational issues or end market?

That's good follow-up.

A little bit of operational issues.

We had trouble making deliveries.

And we think the end market's probably flat, and there's just the chunkiness year-over-year of customer orders.

We had some big orders in the Middle East last year that didn't repeat themselves this year, and that's not a call on the market.

That's just a reflection of our business.

Got you.

And I guess, while we're on the topic of nonres, there's growing concern that the end markets there are slowing.

I think you said new construction was up mid single.

But what do you think the end markets did?

And how are you thinking about the outlook there?

We continue to be steady as she goes.

And you know this, Robert, but I'll say it for others is, where we play in commercial is the unitary space, which is buildings 3 story and below.

We don't play in large institutional.

We don't play in high-rise office buildings.

We don't play in high-rise residential buildings.

And so the verticals we play in continue to bubble and percolate: retail, K-12 education, entertainments, fast food, and those continue to perk along.

And so we see steady growth in commercial, and we called for market to be up low single digits.

We think that's probably where it's going to be, and that's order of magnitude, at least as we sit now, going into '18, what we think it's going to look like.

So I understand all the calls about -- concern about commercial markets.

We're, quite frankly, not seeing it.

Got you.

And just to clarify one thing you said earlier about bringing the growth down in SG&A, that's happening regardless of what price cost does, is that right?

Correct.

Yes, for 2 reasons: One is, we've already -- as I said, strategically, we pull forward investments now.

It's the right thing to do.

Second is, you can't wait for commodities to come in, so you got to take the rightsizing actions now.

You saw we had some restructuring in the quarter, and that helps supporting what we're doing to get our SG&A spend right for 2018.

Next, we have the line of Ryan Merkel of William Blair.

The first question I had was on the hurricane upside potential for residential.

Todd, any guess of how many residential units the industry could see from the hurricane cleanup in '18?

No.

I mean, again, if I had a good perspective and a number that had a reasonable error margin around it, I'd go for it.

But it's really hard to quantify.

So many moving pieces around repair versus replace versus what all the impact was.

And so I've seen, obviously, some of the forecasts that are out there publicly.

I -- the thing I'm confident of is it'll have impact.

I'm confident that the weather will bounce back in residential.

And the fact that we were up 8% in replacement the last 6 quarters in resi, and were only up 2% in Q3, that's both weather and hurricanes.

And we'll see that come back.

All right.

Fair enough.

And then secondly, I'm hearing from some of my channel contacts that there's some new commercial regulations that are going to hit next year and drive prices up 6% to 8%.

Is this something you expect?

And is there any margin opportunity for you?

Or does the rising cost offset the price?

We'll see, and we'll probably talk about that a little bit more in December.

But that's certainly true, the minimum efficiency regulatory requirements are going up in commercial equipment.

And sort of from a technical viewpoint, we have all that in position.

Costs are going up for us and our competitors, and we'll certainly pass that on.

And we've done a very good job historically when there's regulatory changes or when we come out with a new product to go after high efficiency that we're able to leverage our technical capabilities to meet the requirements at a cost point lower than our competitors.

And so, i.e., we are able to get margin for it.

I don't think that will be a material callout.

But we'd always be disappointed if we launched sort of a new product, and didn't either keep margin percentages or have them go up.

Next, we have the line of Julian Mitchell of Crédit Suisse.

Maybe just, firstly, on the balance sheet, in terms of capital deployment, you'd sort of spent what you thought on buybacks in the second half already in Q3.

Your share count guide for the year is unchanged.

So maybe any updates on buy-back planning or any other use of cash?

At this point, I think, it's steady as she goes.

We plan on $250 million of share repurchases in 2017.

We've completed that -- or will complete that, quite frankly, in the early part of the fourth quarter.

We still expect to spend about $100 million in CapEx to support business initiatives going forward.

And when you sort of roll that all up, it gets us to our targeted debt-to-EBITDA ratio, which is between 1.5 and 2, probably the midpoint of that as we end the year.

And right now, we're on track to achieve that.

Got it.

And then your gross margins, obviously down 90 bps or so in the third quarter.

Some onetime factors within that.

But when you're looking at that specific rate over the next 6 months or 12 months, should we be expecting gross margins to be flat to down, offset by SG&A coming in a lot?

Or you think the gross margins should be able to show a recovery fairly soon.

I think the gross margins will see a recovery.

I think what we saw in third quarter, not to continue to flog this answer, but the weather impacted mix.

And when mix is down in our residential business and our Refrigeration business, that impacts our gross margins.

And so SG&A productivity's going to help buffer or help ensure we get to 30% incrementals.

But sort of the core productivity around material cost reduction, around factory productivity, around mix up and volume growth, that has been the hallmark of our story the last 6 years, 7 years, 8 years, that continues in 2018.

Got it.

And then lastly, just -- you called out product investments several times on this call.

Any specific changes or new product rollouts that you'd want to highlight?

Or this is just normal course of business activity.

This is normal course of business.

So we tend to roll out our products in first quarter with our marketplace.

And so it's the areas that you know we're investing: controls, energy-efficient product and all our alternate refrigerants.

And so all those programs, we continue to make investments.

Next, we have the line of Robert McCarthy of Stifel.

In any event, a couple of questions.

I guess, one on -- did you see any difference -- and I know it's tough looking at all of the distorted impacts of the hurricanes, but any difference in kind of trend-line sales between kind of quarter-to-date from July through August through the hurricanes to get a better sense of kind of what the distorted impacts could be?

I mean, you did cite the 600 basis points, I think, break in trend line.

But anything -- any other way you can parse in terms of how business kind of slipped in -- within the quarter to give us some comfort of the disruptive impact?

It's -- I -- of -- in my comments and in the script, tried to lump the cooler weather and hurricanes together, in part because it's hard to disaggregate the effects.

And so when we look at our demand for replacement business, I guess, pre-hurricane, we were having cool weather, and then we had cool -- the weather warmed up some, and then we had the hurricane effect.

I think they both have material impacts on the quarter.

I think quite frankly, weather, since it touched the entire country, had more impact than just the Houston and Florida impacts.

Okay.

I tried.

I guess the next question is, just in terms of pricing and how you're thinking about pricing in the resi channel, I mean, given the environment for probably prospectively for inventories activity in the parts and service side and the outlook, you would expect pricing to be kind of according to Hoyle here going forward?

Are you seeing any kind of concerns around pricing in the marketplace?

Well, I think about it this way.

We're committed to getting the price to offset commodities.

Our industry has a track record of the entire industry doing it.

Our competitors have the same cost structure we have.

They have the same commodity inflation we have.

We're pretty confident we're going to get price to offset commodities and so that's what we're focused on doing.

And the last question is, I mean, obviously, over the longer term, I think you have talked about the opportunities for consolidation in the space, broadly.

Do think there's a prospect that this could accelerate over the next couple of years, that you could see sizeable properties that could be interesting?

I think the only thing I know is that we -- I think value can be created through a combination, traditional industry consolidating synergies, if you will, or margin creation.

We think we're a great position to do it.

Others would have to decide they don't want to be in the business.

It certainly looks right now, there's an environment where industrial conglomerates are getting help on what businesses they should be in.

And if someone gets some help, that they want to exit some of these businesses, we'd love to talk to them.

Next, we have the line of Walter Liptak of Seaport Global.

Wanted to ask about maybe the southeast Florida, Texas, and just how you feel about the distribution channel down there.

Is it a stronger part of your business or something that you need to work on?

How do you feel about the channel?

We love our own distribution channel, and we think our PartsPlus strategy is a very good one.

And all the investments we're making, both in the Southeast and the Southwest and across the country, continue to pay dividends.

I mean, clearly, someone like Watsco is stronger in Florida than what we are, and that's just been historical fact.

But I think if you look at where we were 5 years, 6 years ago to where we are now, and if you look at both market share and physical distribution, we've made some nice gains.

And so we continue to focus on those markets as well as other markets around the country.

Okay.

Of the PartsPlus stores that went in this year, what percentage went into that Southeast region?

I don't know off the top of my head.

We can get you that answer.

But again, it's -- the way we think about it, at least the way, yes, the way we think about it is, we're not trying to win in the Southeast.

We're trying to pick those store openings that create the most value for us.

And that's how we prioritize the investments.

And so if we already have a high share someplace, but we've identified customers we put stores in, we'll really have high share, then that's where we'll put the stores.

So we go where the opportunity is and thinking about it that way.

Okay.

Okay, then maybe a last one, just on the resi business and the new construction part of it.

What kind of visibility do you get this time of the year kind of looking at 2018 and the kind of starts that may take place?

We have strong relationships with the top 20 national builders and especially the top 10.

And we spend time with them.

We have visibility, and they give us visibility about land they own and what their forecasts are.

But sort of like our National Accounts business, it's -- they give us guidance.

They give us visibility.

But if the macroeconomic environment changes, they react to it.

So right now, when we talk to our big builder guys, steady as she goes.

We guided for new construction, our business to be up 10% this year, might be up a little bit more than that.

And as we think about 2018, we're sort of thinking something similar.

But if interest rates were to spike up or something happens to the economy, they can certainly slow down on their building.

Next, we have the line of Josh Pokrzywinski of Wolfe Research.

Just a follow-up on that $40 million of price cost, Todd.

I think from the first time you quoted that number, maybe had a pretty big range around it.

Copper's had another, I don't know, maybe 10%, 15% move, something like that.

Are you just abnormally hedged into 2018 at this point?

Or is that a number that could have some fluidity if copper stays kind of well above $3 here?

Where we're at now -- and again, we've -- our guys, including me, just decided $40 million was easier than me constantly saying order of magnitude twice of what we have this year.

But it is order of magnitude twice what we have this year.

And where copper sits today, we think $40-ish million is the right number.

And that's what the math says, and we're confident we can get that with price.

And then just the part of the equation that, I guess, historically gone kind of unmentioned and not unnoticed, but hard to quantify, is on the purchase component side.

Clearly, your suppliers are going to want a bit more price and maybe contractually, are obligated to get some.

I know that there's always a material cost productivity that you guys throw in there.

But is that a net number or a gross number?

And when we think about that $40 million material sourcing and value engineering number, is that really something higher, and then it comes down based on supplier price increases?

Just trying to get that other pocket of the equation that we can't track on Bloomberg directly.

When we quote a MCR number, the $30 million to $40 million this year, $35 million, it's bottom line net impact.

And so we can literally point to a P&L and see it internally.

And so short answer is, we get price increases from time to time, but we have to outrun those.

And sort of the net number is $30 million to $40 million.

I mean, we used to joke when I was at UTC, if you do it the other way, you can have cost reduction equal to the GDP of small countries.

And so you have to be very focused about how you measure this, and this is a net number.

We can see it in the P&L.

It's after all price increases.

Got you.

And then just to be clear, on the hurricane cleanup side, you said you are seeing some parts pull through as it stands today, people coming back and repairing or, in some maybe smaller cases, replacing equipment?

Especially in Florida, less -- maybe less so in Houston.

But in Florida, we've seen some pickup in parts and supplies.

Got you.

And that's not just from the downtime, where no one was doing anything, because there were, say, branch closures or things like that?

I think it's people repairing units and either, a, repairing units, or getting parts to be prepared to repair units.

The last question comes from the line of Steve Tusa of JPMorgan.

The industry, what do you think the industry actually did in 3Q in resi on a unit basis?

I didn't -- sorry, I hopped on a little late.

I didn't catch that.

And then what do you think, on a unit basis, your kind of -- is that number kind of a same-store basis?

I know you guys open stores every year.

I'm just curious as to kind of what the industry is seeing out there, because you guys are clearly -- seems to be continuing to take share.

The honest answer is I don't know just on third quarter.

I'll come back to that in a second.

On -- what I said on the call was on a full year-to-date basis, our HVAC businesses were 0.5 point or slightly above in share, which is consistent with what we've done the last 4 years or 5 years.

As you know, on -- given some people have independent distribution and the timing of loading and unloading, any given quarter could be skewed.

So if you look at AHRI data, it's that way.

If you look at HARDI data, it's sell-through, and so that's different.

So eye to eye, when we -- and again, we're biased.

But when we talk to our guys on the street, we think we had a pretty good quarter, that only being to have add-on replacement be up 2% and residential new construction be up high single digits, we think we did pretty well.

But we'll -- the numbers may say something different, just given the timing of load and distribution.

I've also heard from the channel that others are kind of going about this kind of distribution storefront kind of buildout.

Did -- some of your peers have started to kind of initiate similar investments.

Are you seeing that out there?

I -- particularly, I know you're not going to talk about specific brands, but I'd particularly heard that Trane is starting to kind of pursue that strategy.

Has there been a bit of a change there from competitors reacting to the success you're having there?

I guess, you guys differentiate because you definitely own more of your distribution.

But just curious if you're seeing anything on the ground from competitors with a response.

No.

I mean, we've certainly heard from public utterances.

JCI talked about it, and to a lesser degree, Trane talked about it.

But again, to your point, we have a big advantage because we own distribution.

And look, we've been clear from the beginning.

We didn't invent this concept, right?

I mean, Carrier's had Totaline stores for 50 years, or 40 years in the field and -- so when they own their own distribution.

And so we're doing what others have already done, and I both -- and so if they want to build out stores, fine, so will we.

But the only caveat I would give to them is, I think building out a store strategy is a 5-year to 10-year strategy that you got to be committed to because it takes that while -- a while to get the virtual cycle sort of heading in the right direction, like we do.

And so we now have a machine, and we just keep marching with it.

If they want to sort of toy with it, they won't have the same results.

Operator, I think that's all the Q&A.

So I want to thank everyone for joining us on the call.

My closing comments are what I said in the script.

The company's well positioned to close out a record year for revenue margin and EPS and to drive strong growth and profitability over the coming year.

And again, thanks for joining us today.

We look forward to seeing you -- are we at the -- which hotel are we at, Steve?

New York Palace.

New York Palace -- I'll put a plug in for them -- on the morning of December 13 for our annual investor community meeting.

Thanks, everybody.

And ladies and gentlemen, that now concludes the conference for this morning.

We do thank you very much for your participation and for using our AT&T Executive Teleconference Service.

You may now disconnect.