特靈科技 (TT) 2010 Q2 法說會逐字稿

Good day and welcome to the Ingersoll-Rand second quarter 2010 earnings conference call. Today's conference is being recorded. At this time I would like to turn the conference over to Mr. Bruce Fisher, Vice President of Investor Relations. Please go ahead, sir.

Thanks, Tom. Good morning, everyone. As Tom said, welcome to Ingersoll-Rand's second quarter 2010 conference call. As you know, we released earnings at 7 AM. this morning. We'll be broadcasting in addition to this phone call through our website at Ingersoll-Rand.com where you will also find the slide presentation that we'll be using this morning. These materials from the call will be archived on our website and will be available tomorrow morning at 10 AM.

If you would, please go to slide two in the slide presentation and I'd just like to remind you that statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities laws. Actual results may differ. Please see our SEC filings for a description of some of the factors that may cause actual results to vary materially from anticipated results.

In addition, if you would, please refer to slide 21 which covers the use of non-GAAP measures to describe Company performance. Now, I would like to introduce the participants on this morning's call. We have Mike Lamach, our Chairman, President, and CEO, Steve Shawley, our Senior Vice President and CFO, Janet Pfeffer, our Vice President Business Development and Investor Relations who is taking over my role and Joe Fimbianti, our Director of IR.

Before I turn it over to Mike and Steve, I would like to thank Joe for his support through the years. I would also like to wish Janet all the best in her new role. I know our analysts and investors will enjoy working with her. Also, I would like to thank Mike, Steve, and the other leaders and people I've worked with over the years at Ingersoll-Rand, Trane, and ASV. It has been a privilege to know all of you. And I would like to thank the folks from the investment community. It has been a pleasure working with you, sharing the ups and downs of the market and together gaining our better understanding of our businesses. Thank you for your energy, your intellect and your curiosity. You've made my job much more interesting, rewarding, and fun. And so with that, if you would, please go to slide number three and I will turn it over to Mike.

Thanks, Bruce. We were talking last night, it was 41 quarters I think we've had the pleasure of working with you for nine of those, so again we want to tell you thank you and wish you all the best. Good morning to those on the call. Thank you for joining us today. In the second quarter we continued our focus on driving top tier operational performance. We delivered strong revenue growth with three of four sectors achieving top line increases. We significantly improved our productivity for the sixth straight quarter and we expanded our margins, grew our earnings and generated strong free cash flow. Second quarter earnings from continuing operations were $0.76 per share, including $0.04 of restructuring and productivity investments. EPS exceeded the top end of our projected second quarter earnings guidance range of $0.62 to $0.72. For the quarter revenues were $3.7 billion, up 7% versus prior year and above the top end of our guidance range of 3% to 6%.

During the quarter we continued to see strong bookings as a number of our early cycle businesses are showing good growth. For the Company overall orders were up 10% and improved in each of our segments except for commercial security which continues to be hampered by the ongoing decline in North American commercial construction activity. Our backlog also increased significantly up 15%. Operating margins for the quarter was 10.3% driven by productivity and higher volumes. All of our segments improved operating margins year-over-year and total segment margins were up 2.8 percentage points for the second consecutive quarter. We also had a 49% leverage on our year-over-year revenue gains. We achieved a 4.4% increase in gross productivity as we continued to drive disciplined cost controls and operational improvements. This performance includes approximately $26 million of unplanned supply chain costs incurred primarily to expedite delivery of some key components to meet strong customer demand. These additional costs caused an 80 basis point drag on our year-over-year productivity.

We also held or gained share in most of our businesses and our innovation agenda continues to gain traction as we increased investment in the development and introduction of critical new products and services. We expect that these actions will help to mitigate some of the near term market choppiness and fuel our growth as the recovery fully kicks in. We also remained focused on cash flow management and in retaining the benefits achieved through the operational attention we've paid to working capital improvements over the course of the past eighteen months. We built up cash in the quarter and are in great shape to repay the $250 million of maturing debt in August and we are on track to deliver $1 billion of available cash flow for 2010.

Please go to slide four. This slide gives a summary of our quarterly order rates from 2008 through the second quarter of 2010. As you can see, we hit the bottom for orders in the back half of last year and reported flat orders in the fourth quarter. Reported orders for the second quarter were similar to the first, up 10% overall, and all sectors except for commercial security enjoyed year-over-year gains. We had especially strong gains in industrial air and productivity, club car, transport refrigeration, in Asia, commercial HVAC equipment.

Please go to slide five. The next slide provides a look at the trends and our revenue by segment. We think revenue excluding currency shown on the bottom of the chart gives a better view of our organic sales performance and our comments will focus on this measure. As you can see on the bottom chart, second quarter represents the first uptick in revenues we have seen in a long time. In fact, we last had quarterly revenue growth in the second quarter of 2008. We had improvements in all of our sectors except for security which was flat overall despite a declining domestic commercial construction market.

I will give you two other views of our second quarter results, a geographic split and a split between recurring revenue and equipment . On a geographic basis revenue improved by about 6% in the US and we're up by 11% in international markets excluding the impact of currency. Equipment revenues were up 7% and worldwide parts and service were up by 8% on a comparable basis with last year.

Please go to slide six. This bridge analyzes the change in second quarter operating margin year-over-year. Second quarter operating margins were 10.3%, an increase of 2.8 percentage points compared with 2009. As you can see, volume, price, and mix on $250 million of additional revenue added 1.6 points to our operating margins. Productivity was the biggest driver and netted against inflation also increased margins by 1.6 percentage points. We continued to invest in new products and those activities coupled with the structuring investments reduced margins by 40 basis points. Our focus on productivity which will reduce our fixed and variable cost structure and our innovation agenda remain core elements of our strategy as we position ourselves for higher margins and faster than average growth as our markets recover.

Please now go to slide seven. This slide explains how we exceeded the EPS guidance range that we provided in April. At that time we indicated that we expect it to be in the range of $0.62 to $0.72 per share from continuing operations with the midpoint value of approximately $0.67. Compared to prior expectations, price was flat for the quarter which caused $0.02 of EPS drag. Higher volumes contributed an additional $0.06 per share. Productivity was better than expected but it was negatively impacted by $0.06 of higher supply chain costs resulting in a $0.04 shortfall to our April expectation. Inflation, interest, and investment planning also contributed to better earnings. Finally, we reclassed our European refrigerated display case business which we are in the process of divesting to discontinued operations and that increase continuing earnings by about $0.02. Steve will now take you through a review of our reporting segments.

Thanks, Mike. Please go to slide number eight. This slide covers the climate solutions segment which includes the Trane commercial HVAC business and the Thermo King and Hussmann refrigeration businesses. Total revenues of $2 billion for the second quarter were up 6% both on a reported and excluding currency effects.

I will talk first about the commercial Trane HVAC business and provide a quick look at the markets. Globally, nonresidential HVAC equipment markets declined mid-single digits in the second quarter. Following a decline in the mid-teens in the first quarter. Both the Americas and Europe Middle East showed midsingle-digit declines while Asia continues to demonstrate good growth. Based on what we see today, we believe the Americas market has bottomed and based on market activity, we may be approaching an inflection point. We also expect Europe-Middle East markets to continue to decline at a slower pace and growth in Asia to remain in the mid-teens. Trane's global commercial HVAC second quarter revenues of $1.3 billion were up 2% versus prior year on a reported basis and up 1% excluding the effects of foreign exchange. Total global commercial equipment revenues were in line with global markets down 5% excluding FX. Americas equipment sales were down close to 10%. Europe and the Middle East were down mid-teens and Asia was up high teens all excluding FX. Global parts services and solutions revenues increased by 11% excluding FX. This is a strongest year-over-year increase we have seen since the fourth quarter of 2008 and reflects both improving demand on our ability to sell directly to building owners.

Shifting to orders global commercial HVAC orders were up 9% and up 7% excluding foreign exchange. This is the second quarter in a row that total order growth was positive. Following the string of five quarters of negative growth. The second quarter was driven by equipment orders which were up 7% and contracting and service orders which were up 13%. Our backlog continues to grow. We ended the quarter with a global backlog of equipment, contracts, service and parts of over $1.4 billion. Global backlog was up 16% on a reported basis. Equipment backlog increased mid-teens while contracting backlog increased by over 20%. Geographically backlog in the Americas was up mid-teens and international backlog was up almost 20%. Asia continues to be strong and Europe and the Middle East were down slightly on a reported basis but up mid-single digits excluding FX.

In summary, although commercial equipment revenues have shown a downward trend year-to-date our recent orders and market outlook suggests that we are approaching an inflection point. Service and contracting are now showing solid growth so far in 2010 and our strong backlog should support revenue growth the rest of the year. In addition, our productivity and restructuring actions are helping to improve margins and we continue to launch new products which will put us in good position to leverage improving markets when they materialize. For the global Thermo King transport business revenues increased by 30% which is consistent with significantly improving markets compared to last year. Our worldwide refrigerated truck and trailer revenues grew even faster, up 39% compared with 2009 with strength in all key regions. Global, bus HVAC shipments and marine container sales both increased substantially due to easy comps and improved end market activity. TriPac auxiliary power unit volumes increased significantly compared with last year based on new product introductions and relatively higher diesel fuel prices. Total Thermo King orders increased by 22% in the second quarter setting the stage for continuing improved sales and operating earnings for the balance of 2010. Looking at stationary refrigeration, global revenues were down 1% excluding the KOXKA for European business. Overall bookings increased by 4% in the quarter.

North American display case revenues were up 5% primarily driven by supermarket upgrades and remodeling projects at several of our major customers. We have proactively reduced our participation in some low profit contracting projects resulting combination of better product mix and productivity helped to improve our North American margins by 3 full points in the quarter. Operating margins for climate solutions was 9.7% in the quarter compared with 7.7% last year. This 2 point margin improvement was driven by volume gains, productivity, and cost reductions and better mix.

Please go to slide number nine. Industrial technology second quarter revenues were $625 million up 16% on both a reported basis and excluding FX. Industrial markets are clearly recovering after stabilizing in the first quarter. Orders for air and productivity products were up 29%, so strong improvements in all geographies. Club car revenues increased by 27% compared with last year as demand picked up in both the Gulf and utility vehicle market. Year-over-year golf car market share also improved. We have seen a significant increase in orders from golf car replacement demand and total bookings were up 19%. Industrial's operating margin of 12.6% was up 5.5 percentage points primarily from higher revenues, better product mix and productivity.

Please go to slide number 10. The residential solutions sector which includes Trane and American Standard HVAC product lines and the Schlage security residential business had second quarter revenues of $641 million, up 10% compared with last year. Excluding foreign exchange, revenues were up 13%. It appears we have finally reached the turning point of the long down cycle in the residential market and we expect improvements going forward driven by strengthening of the replacement market for residential HVAC and slowing improvement in the residential construction. Total reported revenues for residential security portion of the sector were down about 8%.

North American revenues were up about 7% primarily due to an improving remodel market and a bottoming in the US new builder channel. This improvement was offset by South America's results which included significant negative currency translation related to the devaluation of the Venezuelan bolivar. The HVAC business we estimate the industry shipments in motor bearing units increased by about 9% over prior year. Our residential HVAC sales were up 14% principally from improvements in replacement sales, channel restocking, and the introduction of new products. Operating margins of 10% increased significantly compared with 2009 driven primarily by volume and productivity.

Please go to slide number 11. Revenues for security technologies were $421 million, down about 1% and flat excluding currency. America's revenues in the commercial sector were down 6% outperforming the 20% year-over-year decline in commercial construction markets. Our European security business was down approximately 2% on a reported basis and up 4% excluding currency. Asia revenues were up over 40% with increasing sales in China. Operating margin for the quarter was a very strong 21%, up about 50 basis points despite the negative mix effect from the North American sales decline. Strong productivity and somewhat lower investments drove the improvement in margins.

Please go to slide number 12. Let's switch gears to talk about productivity. As you know we have set a long-term goal of delivering 5% gross productivity every year. For 2010 our target of 5% total productivity translates into savings of approximately $650 million. In the first quarter we achieved $151 million in savings in line with our expectations. For the second quarter we achieved similar productivity of $149 million or 4.4%. We were very disappointed with the fact that we incurred an unexpected cost associated with inefficiencies in the supply chain and in some of our factories as we ramped up to meet the higher volumes. This translates to about eight-tenths of a point in lost productivity. These issues have largely been rectified and we don't expect any significant lingering after affects in the second half of the year.

We are continuing to target our full year productivity savings of 5% with a divestiture of KOXKA, our new savings target becomes $634 million. In effect divesting KOXKA allows us to accelerate the earnings improvement we would have achieved over time as planned within our footprint rationalization program. By moving KOXKA to discontinued operations and restating history, this earnings gain will not show up as productivity. A decision to divest KOXKA also avoids cash restructuring expenses that would have otherwise been incurred.

Please go to slide number 13. This chart updates our manufacturing overhead and footprint and improvement programs. As we've said, this is a long-term program. So far this year we've announced nine manufacturing plant closures and about four -- I am sorry, and four product line movements. The KOXKA divestiture also removes two additional manufacturing facilities bringing the total to eleven fewer manufacturing sites globally. We spent about $15 million of our productivity investments in the quarter on these programs and are on track to achieve our savings target.

Please go to slide number 14. In addition to our productivity programs, we continued to sharpen our focus on developing and launching new products and services. We expect about 18% or $2.5 billion of our 2010 revenues to be from new products and services introduced in the last three years with a number of new offerings in each of our businesses. This is up from approximately $1.8 billion or 14% of sales in 2009. We are increasing our 2010 spending on innovation related investments by the equivalent of $0.15 to $0.20 per share over 2009.

This slide shows four of the new product thats is launched in the second quarter. Just to highlight two of them, residential solutions new secure key feature which is on all Schlage residential products is shown on this slide. It is a high security pick resistant lock cylinder which enables home builders and homeowners to change keys at any time using an easy two-step process that takes seconds to complete. Secure key technology enables ten times more key cut combinations than other locks making the secure key design ten times more secure for the key duplication than other rekeyable systems the market.

The hammer head low profile impact tool offers the power of an impact with the reach of a ratchet. It is going to change the way our customers work. The hammer head fits into tight spaces and eliminates awkward extensions and swivel sockets which improves customer productivity. Reinvesting in our business is critical to our future growth. We have a growing pipeline of product and service innovations many of which are synergistic and combine capabilities across our businesses. Much of what's in the pipeline is unique to Ingersoll-Rand and will continue to strengthen our market positions.

Please go to slide 15. We continued to achieve our deleveraging goals during the second quarter. Total financing was reduced by $46 million in the quarter and $212 million year-to-date. Cash balances ended up at $822 million as we continue to build cash in anticipation of paying a $250 million maturity in August. We also successfully reinstituted a three-year $1 billion credit facility in the quarter and now have $2 billion of available credit facilities. We reduced our total financing by roughly $2.2 billion since the completion of the Trane acquisition in June 2008.

Please go to slide 16. We finished the second quarter with working capital at 2.9% of sales, down 3 percentage points from last year. The $147 million working capital increase from year end 2009 is typical for this time of year as production is ramping to meet seasonally high volumes in the second and third quarters. We expect to maintain working capital sales in the range of 3% to 4% for the full year through improvements that have been and are continuing to be made in manufacturing systems and processes, footprint restructuring, and supply chain and logistics management.

Please go to slide number 17. Year-to-date we're ahead of plan due to higher than expected earnings and ongoing working capital management focus. Second quarter available cash flow of $283 million also outperformed due to cash timing differences from our plan for some major restructuring actions and CapEx programs. Based on this first half performance and the timing of investments we remain on track to deliver the $1 billion available cash flow plan for 2010. With that I will turn it back to Mike for the forecast.

Thanks, Steve. Please go to slide 18. Our forecast for the balance of 2010 is based on mixed but improving markets. We continue to expect a slow recovery in the US, European economies, growth in Asia and mixed activity levels in our major vertical end markets. We believe recent activities indicate that we are seeing stages of recovery in refrigeration, industrial, club car, residential HVAC and residential security as well as in commercial HVAC, parts, contracting and service. We expect to see a continuation of the challenging conditions in the US nonresidential construction market for the balance of the year which will continue to impact both Trane and security commercial business.

We are certainly encouraged by our orders and backlog but economic turns can be choppy, so we believe the best approach is to be conservative in our market outlook and continue to focus on achieving our productivity targets offsetting material inflation through price realization and continued investment in our long-term growth through innovation. Based on this mix but improving view of the world, we are raising our revenue range for the full year 2010 to up 4% to 6% compared with 2009. We expect industrial and residential to show gains in the upper single-digit range, climate solutions revenues expected to be up low to midsingle-digits with low single-digit declines in HVAC equipment and gains in both refrigeration, contracting, parts and service. Security is expected to show a year-over-year decline due to its exposure to nonresidential building, especially in North America. This results in a full year forecast of $13.7 billion to $13.9 billion equal to a 4% to 6% full year growth for total Ingersoll-Rand. This compares to our previous revenue guidance of 3% to 5%.

Please go to slide 19. As a result of an improved revenue outlook, we're now projecting full year 2010 EPS from continuing operations including restructuring and excluding $0.12 of one-time healthcare costs to be $2.18 to $2.38 per share. Additionally our forecast is built on the following assumptions. Our full year forecast assumes modest price realization year-over-year, a tax rate of about 19%, $0.25 per share of restructuring and productivity investments, and EPS based on a 341 million share count. Third quarter revenues are forecasted to be in the rage of $3.65 billion to $3.75 billion which is up approximately 5% to 8% compared with the third quarter of 2009. EPS from continuing operations is expected to be in the range of $0.70 to $0.80 again, including $0.08 of restructuring and productivity investments.

Please go to slide 20. Slide 20 is a summary of our forecast for the balance of 2010 and all of the related components. To sum up the forecast for 2010, we expect to demonstrate our focus on driving towards top tier operational performance across each of our businesses. While steadily increasing delivery of customer focused innovation and products, systems, services, and business models. We expect to see improving revenue growth and significant earnings growth as we continue to deliver on these objectives. Steve and I would now be happy to take your questions.

(Operator Instructions) We'll go first to Robert worth timer with Morgan Stanley.

Good morning, everybody. I had a couple questions on the commercial businesses. On the commercial HVAC are you seeing a lot of stimulus effect if any and if you're not seeing it, do you feel like it is ahead or it is not happening?

Rob, from the get-go it has been disappointing from what others thought it would be. It is not a subject of major positive variances in any of the business reviews that we do. I think there is some effect to it, but I do not see it as a major tail wind or driver for us.

It is interesting. Do you have a sense as to how the district will -- took people awhile to plan and get involved or you're just not seeing it in the pipeline either?

Just not seeing the flow of funds really. As opposed to go back to China where we had 30%, 40% bookings growth and we had our factories filled with high efficiency equipment, chillers and aerial units which I would say was a direct result of the stimulus work there.

Given that, the orders are still -- the revenues are okay and the orders are trending up which is positive. Are you able to say whether the repair and replace side of the business is sort of above trend as you're getting a balance from people not doing work last year or are you seeing strength in both -- there isn't a whole lot of new build. I am just curious about whether you are seeing above trend line repair and replace or just back to normalcy.

I think it is a business that when we look long-term we think we have the ability to grow that business 8% to 10% annually. I think there is some catch up. I think there is some particularly early in the year where 2009 budgets were constrained. I think there was some early spending by customers to make sure they were going to be able to spend and in the event there would be a W-shape recovery and maybe have budgets cut. I think there is a little bit of that. I expect long-term that we can grow that business 8% to 10%. It is an enormous business, very fragmented with a lot of global opportunity for us as well.

If I can stick in one last one, your margins on your security business continue to be just very, very strong. Is that at all -- you didn't mention as one of the factors in the innovation, I don't know whether that Schlage idea is big enough to matter, it's a brand new launch, is it innovation, is it aftermarket or again shift in mix or is it just improvements you made to the business?

It is interesting because the Schlage idea is ahead in the marketplace and it actually does sell at higher margins than our mechanical product. But I would also tell you it is really outstanding operational improvement in Europe and Asia offsetting that mix.

I will stop there. Thanks.

We'll take our next question from Jeff Sprague with Vertical Research Partners.

Good morning, everyone. First on the Q3 guidance, Mike or Steve, with relatively flat sequential revenues and presumably the absence of the repeat on the supply chain pickup, and presumably a little bit more time for just internal actions on costs to come through, why wouldn't conceptually earnings be higher in Q3 than Q2?

Good question, Jeff. What happens to us is there is a shift in the restructuring productivity investments. We pick up a significant increase in the third quarter versus the second quarter, and so if you look at the $100 million of restructuring productivity investments we have in the year, it is predominantly second half oriented, and we will be reloading the cannon here in the third quarter pretty significantly, so just about offsets the $26 million of inefficiencies almost dollar for dollar.

And on that issue, Mike, probably relative to the kind of all the macro concerns just the internal execution on moving the plants around and all that is kind of front and center on everyone's minds, the plants are still relatively empty I think it's probably fair to say. What was the nature of the hiccup there and was it an IR execution problem or was it a supplier problem? Sounds like maybe it was a little bit of both.

Great question. Again, I would separate the two issues here. One is the reduction of 11 rooftops for us, nine that we've announced and two that we will divest. Independent of that I can tell you that the actions that we took there did not relate to any of the issues we had in the supply chain. The issues that we have in the supply chain and this is something that I want to convey on the call and I will start by saying we're really trying to give all of you guys excellent guidance and of course adjust if we think we're going to miss it or substantially overachieve it. We're also trying to give you a lot of transparency on these calls as to what's going well and a bit more balanced view, and certainly when you beat like we did we probably could have buried that in operational performance, don't know if there were too many questions that, I think we see it as we had entitlement for $0.04 and we missed it and it came really down to what I would call the science of sales, inventory operational planning. And how we material plan and work with a supplier. It was in the res side of the business primarily and I think we have got the issue addressed. In fact we brought in a leader working for Todd in the last couple of months as we ran Dell (inaudible) program for them to head out this function. I think it is so important going forward. Independent, Jeff, the closures and announcements are going well. We made a series of announcements last Friday because they were European in nature. We tried to put those together and actually delayed a little bit in the second quarter to the third quarter so that we weren't announcing closures in Europe one at a time and going through death by 1000 cuts there which isn't good for our people or the market. That was the reason for the pushout -- for the pushout there as well.

Just one other quick one if I could. On the $0.15 to $0.20 of incremental spending on new products, has that number changed relative to the plan?

No. It has always been the same. It is the same number.

Okay. Thank you very much.

Thank you.

We'll take our next question from David Raso with ISI.

Good morning. Looking at the guidance for the second half, we don't have the exact year ago with the divestiture, but looks like you have the revenue growth of 6.5 then going down about 4.9 in the fourth quarter, and I am just trying to think about the order book. You're up 10%. What's the visibility in that order book? Is it mostly 90 days? How much into the fourth quarter? I am just trying to think through is it a generic macro conservatism, it looks like from the recent economic indicators or is there something in your order book that you're seeing for the fourth quarter that had that much slower growth year-over-year?

Dave, I think it is more of the macro concern. Typically our order backlog is maybe three months and we only have several product lines that go out for maybe six, but it's a very, very small percentage of our portfolio. I think when you look at this and there's still to quote our Fed Chairman the other day, Uncertainty in the markets, even if you look at the cyclical -- I am sorry, the sequential bookings and revenues within month to month in the quarter, you see those moves happening, so--?

Can you help us with that? How were the orders trending April, May, June.

This is Mike. One thing I would tell you that we think we have actually hit the bottom on some of the unitary business in the US, but it is so early to call that as a definite bottom that I would tell you it tends to be fairly conservative. It has been a little bit surprising that there has been some flattening here and sort of the order activity there would suggest that we may have reached that bottom. I just don't know if we really have. I think that's where the conservatism comes in.

Which businesses are you expecting the most if the conservatism proves to be just accurate?

To be inaccurate it would be a benefit to the Trane, commercial, and security commercial businesses. If it is inaccurate I think we have adequately forecasted it okay. We're taking a middle of the road view here that it is going to be choppy.

So those are the swings. And then trying to think about the back half loaded productivity costs. You had $0.19 out of $0.25 for the year in the back half. How should I think about I assume you have those savings coming in more '11 given the spending is so back half this year. We have got $634 million of total productivity for '10. How should I think about the way it is back half loaded in the '11 savings?

I think if you look at the breakdown, $150 millionish plus $140 millionish, so $300 million of the total is in the first half.

But looking to '11 a lot of your activity, your spends, which obviously are the future restructuring benefits is back half loaded in '10.

This is Mike. Absolutely what we're doing here in the back half of 2010 is 2011 productivity, and the idea here is we're largely through Phase I as we call it in terms of those actions and feel like we've executed against that and what you see here is really the keying up and loading of what we refer to as Phase II action.

Quickie for '11 for the business segments then where are those productivity initiatives most significant in the back half of this year when we think about quarterly '11.

I will defer a little bit. These are plans that we haven't announced internally and haven't fully vetted so I am going to defer that for a quarter and I understand your question.

I can appreciate that. Okay. Thank you.

We'll take our next question from Eli Lustgarten with Longbow Securities.

Good morning, everyone. Nice quarter. Can you talk a little bit about your cost price issues as they came up through the quarter? I mean, in the presentation you had pricing down a little bit. Can you talk about what's going on there and do you expect pricing through--?

Did we get cut off, Eli?

One moment. He left the queue. It will just take me a moment to open up his line. Mr. Lustgarten your line is open again.

You did not hear me before, I guess?

We heard about pricing, costs, Eli, and then you dropped off.

Can you talk a little again pricing in the presentation was slightly negative. You expect it again, you don't know what's going on in pricing and going on with focus on where within the Corporation you're having some issues? Can you also talk about material prices being a little less favorable but inflation was more favorable? I guess you are separating the two out. Can you give us a cost price snapshot of what's going on?

First on the pricing side a couple of quarters ago remember we started introducing something called top line margin expansion was an initiative to raise pricing systematically, program office, external resources, internal resources to focus on that. Felt like we would be seeing that late this year, some benefit late in the year in that regard, and so as you look into Q3 and Q4 there is a higher pricing expectation where those initial actions begin to come through in the marketplace. Sequentially from quarter one to quarter two relative to price we improved slightly Q2 to Q1. I mean, Q1 was really flat. It was a 10 basis points decline. Q3 we picked it up modestly, and maybe a 60 basis points price improvement happening there, but we're also factoring in that we're looking at the possibility of higher inflation in Q3 and Q4.

And can you talk about the difference between the -- you said material costs favorable but you said inflation was less, I guess you separate was difference between the two or what were your--?

Eli, if you look at where we thought we were going to be in the second quarter, just focus on that and kind of take it from the guidance in the second quarter by the pieces, what Mike just went through in pricing if our pricing wound up to be a little bit unfavorable to where we thought we were going into the quarter. That's offset though by the fact that inflation was less than we expected simply because we didn't see the prices -- increase in prices in certain commodities like steel and other that we had forecast at that point. In fact, what happened was the favorable inflation that we saw in the quarter relative to our guidance was slightly offset by price so net between price and inflation we probably picked up $0.01 of improvement.

Okay.

Then you look at you talked about the inefficiencies, but we also were pleasantly surprised with the pull through on the additional volume relative to where we expect it to be in the second quarter. Those are the big pieces.

And you have a little bit, it looks like you picked up some market share at least in the second quarter probably into the third and the Citi HVAC business. I mean, the HRI data so sort of the decline in the business was quite a bit stronger in the North America than what the trade association was showing. Is that true? Is that what's going on?

I think the HRI data says that. We agree. I think it is a lot of the new product introductions. We have the new 13 tier product out, launching now, the 14 tier product, and sort of the new furnace products in place, so I think that the pipeline is really starting to matter here.

One final question is there anything that would prevent the security business from maintaining those wonderful margins despite the softness there have been?

No. We think that that's going to be a pretty steady perennial sort of 20%ish OI business for us.

Thank you.

Thank you.

We'll I take our next question from Nigel Coe with Deutsche Bank.

Good morning. Just to kind of follow onto Eli's question on pricing, sounds like the price inflation gap of 2 points in the quarter was slightly better than what you expected. Is that correct, and then secondly how does that then gap trend over balance of the year?

You are correct on the second quarter, Nigel. What we look at, what we have in the forecast for the third and fourth quarter is a pickup in inflation. It is primarily being driven by steel prices. If you look at steel prices in the marketplace as they're coming up. Steel is not good because a lot of our sub component suppliers use steel and index us whenever the prices go up. What we have in the third and fourth quarter is an increase in price realization to offset some of that pressure on inflation. We're continuing to match the two in a way that says that we're driving price with the commodity inflations that we're seeing, but there is no question in the way we put this together there is more inflation in the back half than there was in the first half.

Okay. Can you then maybe describe the pricing actions you have taken so far and the current reception you have had of your customers and distributors?

I think the most success we have had has been in security technologies commercial area. They were able to raise price this year and have it stick. I think what's going on across the league is that pricing, at a price list level is remaining relatively flat, fairly stable. What we're focused on and we talked about this several times is something that we call our top line margin expansion program. It is not so much going out and increasing price list but it is taking the waste out of the waterfall of margin that occurs between the customer price and what we actually take in to our net sales line. That would be things like volume discounts, it would be things like trade allowances, other things, freight recoveries, recoveries rebate programs that are more differentiated than anywhere in the past based on current volumes and projected volumes. Those are the kinds of things. That's why it takes a little bit longer, Nigel, then it is not necessarily -- we've had businesses that have done price increases but necessarily across the rest of the Company it is more around as Steve said this gross to net.

And so if I answer that correctly, pricing is say flat, Mike, into 3Q so if we go up steel price inflation, does that mean that gap widens in 3Q?

We expect to get some price realization in Q3. Think about it maybe in the sort of 0.5 point range, and I think a lot of that is going to be through what I talked about as being gross to net top line margin expansion programs. We would see that picking up even further into Q4 maybe around 1 point in Q4 as we believe we should get full benefit of what we put in place now almost a year ago to that point, and for the year it puts us up a little bit maybe 40 basis points in total for the year. Again, the only wild card I would tell you, Nigel is if we don't get the inflation, if we're able to either void that through component part prices or if we're able to actually see less commodity inflation, there is a little bit probably of relief that we'll see there as well.

Great. And then just--?

I'd just add to that very, very clear in the third quarter that gap between price and inflation is wider, i.e. more negative than it is in the fourth quarter.

Okay. Great. And then on residential can you maybe just talk about how July started off in terms of HVAC shipments relative to your particular performance and maybe describe what you have seen in terms of inventory levels within the channel?

I am going to hold off on July, Nigel, but I will tell you that from what we can assess we have got about 9 to 10 weeks of supply out into the channel which is about right. I don't think we're going to see a major restocking. Hot weather we can see increased sell through, okay, but I don't think we're going to see restocking here. I think we're about right as far as that goes.

And how does that change during the quarter, Mike?

During the second quarter it was quite lumpy. You saw a really big April, May was actually a little bit of a negative for us, and June was marginally positive, so it was very high, low, and then more moderating. Orders follow the same pattern, April we were up north of 15, May we were up sort of north of 8, June closer to 7, and so I think it is coming down into this view that we're going to see high single-digit for the year, but I don't think it is going to be anything north of high single-digit.

That's great. Thanks.

We'll take our next question from Alex Blanton with Ingalls Snyder.

Good morning.

Good morning.

You mentioned or you made reference to macro concerns when talking about the second half earlier in the call. Could you elaborate on that? What are your concerns about the rest of the year and next year?

It is really around security and commercial, it's around commercial spending. It is not only speculative construction and retrofits, but it is commercial office buildings undergoing renewal and enough confidence in the owners of those buildings that there is an opportunity there to either track tenants or raise rates for these improvements, so I think it comes down to consumer confidence, up at the sort of commercial investment level. I also think that later in the year you may tend to see some of the customers that we've got potentially trying to spend a little bit ahead again, but I think that that bubble is probably not sustainable. At some point in time I think customer budgets become more stable, more reliable, and you don't see the spikeyness in that during the course of the year.

I think, too, that a little nervous about and I don't have any -- this is more anecdotal, but I worry a little about during this recession what would have happened to small business credit lines and the fact that I don't know that small businesses in some ways are going to be able to restore those lines and have the working capital they had in the past to rebound, so I worry a little bit about that. Hopefully we won't see that in our DSOs and we haven't seen that to date. I do believe there are constraints with some of our distributors out there.

Thank you.

Thank you.

We'll take our next question from Bob Cornell with Barclays Capital.

A couple of questions. The intrigue with the comment about approaching an inflection point in the commercial HVAC business. Could you just expand on what you are thinking there and talking about orders, shipments, what?

Yes. It is both, right, so it is a trend you can see where unit area is beginning at the shallow and bottom closer to single-digit declines. Early I would say June, June bookings, we're showing actually even a little bit of favorability at one point slight to prior year. You just get the sense that that market really has bottomed now into small to mid-single digit declines, Bob, and too close to call. You would love to see one more quarter or a few more months really of booking activity there, but it just feels better in the activity we're seeing. I would also tell you the activity we see before a booking relates to the amount of proposals and the amount of activity we're doing with customers and that just seems to be feeling better as well.

Well, the business was down 5 in this quarter. Are we just going to see flat to up in the next quarter based on the tracking up on the other side of the inflection point?

Yes. I think you could see -- I would probably say break even. I would say I would expect something around flat, zero, which would be a pickup.

On Thermo King you mentioned the revenues up 30%. Did they have the kind of flow through in contribution margins as you would expect with that kind of volume gain?

They sure did, Bob. Quite frankly, we were also a little bit surprised because we saw some pickup in the Thermo King business in Europe, and it is one of the other wild cards here is what's happening in Europe, and some of our businesses we actually saw some upticks in June.

Well, then the analyst says with the stationary up 3 points, Thermo King up, does that -- what does that suggest for the commercial business in terms of profitability in the quarter?

Usually lead a little bit, Bob, so that's why I would say those are good trends to us relative to commercial activity, but that typically for three to six-month lag--?

What I am driving at is you had a 2 point margin gain for the segment as a whole, right, and stationary was up 3 and I would imagine Thermo King was up more than that. That suggests commercial was down. Is that a correct read on the subject?

No. I think that Thermo King has been very profitable throughout this. In fact, if you look back at 2009 one of the things that really kind of underpinned what was happening is the fact that Thermo King looked a lot like security technologies in 2009, held their head up through that recession, so you didn't get that big of a pop at Thermo King.

Okay. So commercial equipment was up in margin?

It was up but was very small. I would say marginally up.

Just one other final question on price. You had a lot of price questions. The price question I had is in the backlog, in the orders you are taking in commercial equipment, how does that pricing compare to the pricing in the June quarter shipments?

We focused a lot on pricing in regional markets. If you look at what was going on in China in the fourth quarter and the first quarter, a lot of volume, didn't see much upside, but we fixed that and we have gone out and made sure that pricing discipline is in place with the quotations that we have got out there, and quite frankly some of the leakage we saw in the first quarter was pretty well cleaned up in the second. Our challenge is going to be turning positive in the third.

Okay. We'll be watching. Thanks.

Tom, we have time for one more question, please.

All right. That final question comes from Jeffrey Hammond with KeyBanc Capital Markets.

Good morning, guys.

Hi, Jeff.

Hey, Mike, I know you said you didn't want to touch too much on July. Just in general can you give us a sense if you have seen any deterioration near term? I know there is a lot of concern about Europe, slowing in China, I mean any pockets where you are starting to see things wane?

Keep it simple here. Relative to the guidance we just gave you and we feel like it is achievable, and so we baked in all that we know at this point, and I am not feeling or seeing anything different that would move us away from our guidance here.

Great. Thanks.

I guess we could probably take one more.

We'll go with Steve Tusa from JPMorgan.

Congratulations, Bruce, and we'll miss you on these calls.

Thank you.

I am just kidding. Can you walk through and maybe I do mean that but I just wanted to maybe walk through a little bit more on the commercial HVAC. That's obviously a massive lever for your Company, almost 40% of your business is related to commercial HVAC. And it is interesting that you guys corroborated with carrier talking about a North America business up high single digits. Seems like the turn is coming a little bit sooner than expected. Can you maybe you mentioned unitary was flattish, I guess. Was that in orders or shipments? It is a quick turn business so maybe it is both.

Order is -- we haven't seen the flatness yet in orders, but I would say that the trending is looking positive, and when I was answering Bob's question, when we were trying to call a bottom here, it would appear we're reaching an inflection point in orders, and that's not a long cycle ship for us. Typically that's going to be usually within a quarter but a little bit might slip four months from initial order but relative to quick turn around, applied, we had plants in China, certain of our compressor plants were 100% wide open full capacity, phenomenal activity going through those plants, both in terms of orders, ships, and obviously the activity going through the component plants applying those were strong as well. That was a real positive for us.

What was applied in the US orders or orders or shipments, either one?

Yes. So applied, much closer to break even at this point than unitary. Ahead of unitary. Unitary would be high single-digit negative approaching low single-digit.

Wow. So what is driving that? Is that building owners, government incentives, spurring building owners, it just seems a little bit early given what we're seeing in commercial real estate and the financial metrics in commercial real estate--?

One of the things is that the contracting and service business which for us large turnkey contracts or performance contracts are way up, and that sort of demand creation where you pull through your own equipment, so that is actually playing through now, too, so big contracts that we would have booked are pulling through activity in the plants, particularly in these performance contracts are typically going to be applied projects, and that's what you're seeing I think coming through at this point.

The applied cycle last cycle was not that great. Everybody talks about pent up demand in residential. Do you think there is any pent-up demand on the applied side given that this installed base is now ten years older than it was last cycle and maybe you're getting into the heart of the commercial real estate boom of the late '80s and the '90s? Is that a fair -- have you looked at that at all?

Steve, it is not quite that way because again if it is a 10 plus year old chilled water plant and we're going to be able to go in and if the customer is willing to do a performance contract pay overtime savings, we're going to be able to find an opportunity for the customer to get what they want. A real big opportunity would be if administration were to put in effect let's say a filler of the residential program, a commercial program for energy efficient buildings, I think that would make these paybacks even sharper and create even more demand, so that would be an opportunity.

And then one last question. Last cycle I remember ASDs, you talk a lot about the very strong incremental margins on the commercial equipment side. Are commercial equipment margins -- where are they today just in round terms and where could they go over the course of the next cycle or maybe if you could give a spread of from peak to trough what the swing is if you don't want to give us numbers on where they are today?

Steve, I don't have in front of me the margin breakdown between applied and unitary here.

Just in general, total commercial equipment.

We would expect similar to what ASD talked about in the past and through all the work things we have been doing around the refootprinting work to get significant leverage off that business similar to what we look for any other business. We're looking for the same couple of points of margin growth per year for multiple years here, that we would in any of our businesses, so when we said this is a 14% to 16% business in the long run, I guess to hold us accountable to that you ought to be looking for a couple of points of margin growth every year, clearly volume would make that happen faster for us.

And none of this is in your guidance this year, correct, this is where you're being conservative? You see a pickup in the back half.

Our guidance this year includes all of the footprinting work and restructuring we have done this year for sure, absolutely.

Not the sales volume?

Right.

Right. Congratulations again, Bruce. Good working with you.

Thanks, Steve. Take care. If we could just if I could close by saying thanks again for joining us. There will be a replay of the call for the next month or so, so if you would, just check with our website and all of the contact information is there. If you have any further questions, please by all means call Joe Fimbianti or Janet Pfeffer and it has been a real pleasure. Thanks again for tuning in.

This does conclude today's conference call. We appreciate your participation. You may disconnect at this time.