Steve Harrison - VP, IR Todd Bluedorn - Chairman and CEO Joe Reitmeier - CFO.

Tim Wojs - Robert W.

Baird Gautam Khanna - Cowen and Company Steve Tusa - JPMorgan Jeff Hammond - KeyBanc Capital Markets Robert Barry - Susquehanna Financial Group Julian Mitchell - Credit Suisse Ryan Merkel - William Blair Jeff Sprague - Vertical Research Partners Rich Kwas - Wells Fargo Securities Josh Pokrzywinski - Wolfe Research Robert McCarthy - Stifel, Nicolaus & Co.

Chris Belfiore - UBS Walter Liptak - Seaport Global.

Ladies and gentlemen, thank you for you standing by. Welcome to the Lennox International Second Quarter 2017 Earnings Conference Call. At the request of your host, all lines are in a listen-only mode. There will be a question-and-answer session at the end of the presentation. As a reminder, this conference is being recorded.

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

Good morning. Thank you for joining us for this review of Lennox International's financial performance for the second quarter of 2017. I'm here today with Chairman and CEO, Todd Bluedorn; and CFO, Joe Reitmeier. Todd will review key points for the quarter and Joe will take you through the company's financial performance and outlook.

To give everyone time to ask questions during the Q&A, please limit yourself to a couple of questions or follow-ups and re-queue for any additional questions. In the earnings release we issued this morning, we have included the necessary reconciliation of the non-GAAP financial measures that will be discussed to GAAP measures.

All comparisons mentioned today are against the prior-year period unless otherwise noted. You can find the direct link to the webcast of today's conference call on our website at www.lennoxinternational.com. We will archive the webcast on that site for replay.

I would like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risk and uncertainties that could cause actual results to differ materially from such statements.

For information concerning these risk and uncertainties, see Lennox International's publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

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

Thanks, Steve. Good morning, everyone, and thank you for joining us. Lennox International posted strong revenue and profit growth and a record quarter in which the company hit new all-time highs for revenue, total segment margin and profit and earnings per share. Company revenue was up 8% led by 14% growth in our residential business.

On a GAAP basis, operating income rose 9% to a record $175 million. GAAP EPS from continuing operations was up 8% to a record $2.71. On an adjusted basis, total segment profit rose 14% to a record $183 million and total segment margin expanded 80 basis points to a record 16.6%. Adjusted EPS from continuing operations rose 12% to a record $2.83.

Turning to highlights -- to the highlights in our business segment for the second quarter. In residential, the 14% revenue growth was driven by strength in both replacement and new construction business. Replacement revenue was up low double digits.

New construction revenue was up more than 20% as the team continues to execute well and serving the needs of national, regional and local builders. Residential profit was up 21% as segment margin expanded 130 basis points to 21.5%.

On the operational front, we continue to invest in R&D and IT to support initiative -- innovative new products in the future growth of the business as well as investments to further expand our distribution footprint. We opened three new Lennox PartsPlus stores in the second quarter to bring the total to 216 stores.

We continue to focus on both opening new stores and leveraging our existing investments by driving same-store sales growth. In Mexico, we're on track to realize $6 million of savings this year in our manufacturing operations. Turning to our commercial business; we've seen lumpy customer demand in mix in the first half of this year.

We had a record first quarter with commercial revenue, margin and profit showing strong growth. In the second quarter, revenue was up 3% at constant currency with segment margin down 140 basis points to 17.3% and profit down 6% from the record second quarter a year ago. Commercial margin decline in the second quarter was impacted by two factors.

First, we had large orders from certain national account customers that were a lower product mix for us that shift in the quarter and skewed segment results. Second, national account business has longer lead times in realizing the benefit from price increases as contracts are in place, come up for renewal over time.

In the second quarter, we still had commodity cost ahead of the price benefit. All that being said, as we look to the second half, we expect commercial revenue, margin and profit to be up from the prior-year period.

Looking at the commercial revenue drivers in the second quarter, replacement revenue was up high single digits on strong growth in both planned and emergency replacement. Commercial new construction revenue was down mid-teens year-over-year in the second quarter after being up mid-teens year-over-year in the first quarter.

Overall North America commercial equipment revenue was relatively flat, both for national accounts and non-national accounts. Looking at new national account equipment business, Lennox won 12 new customers in the second quarter on top of the 14 wins in the first quarter for a strong first half of new business for the future.

New customers in the second quarter included healthcare facilities, restaurants, retailers, hotels and property management firms. On the commercial service side, our national account service business showed strong growth in the second quarter up mid-teens.

Our VRF equipment business showed nice growth again and in Europe, commercial HVAC revenue was up high single digits in the quarter. In refrigeration, revenue was down 1%. From a regional perspective of constant currency, Europe was down more than 20% and North America, South America and Australia were up low single digits.

Asia was up low double digits. Refrigeration profit rose 1% as segment margin expanded 30 basis points to 11.4%. We continue to expect segment margin to be up 50 basis points to 100 basis points on a full-year basis.

With our strong balance sheet, we continue to make key investments in the second quarter to drive the future growth and profitability of the company. Beyond that, the company paid $18 million in dividends and $100 million for stock repurchases in the second quarter.

We plan on $75 million more stock repurchases in the second half of the year to bring the total to $250 million for the full-year. Now I'll turn it over to Joe..

Thank you, Tod and good morning, everyone. I'll provide some additional comments and financial details on the business segments for the quarter starting with residential heating and cooling. In the second quarter, residential revenue was a record $654 million up 14%. Volume was up 13% and pricing mix combined was up 1%.

Foreign exchange was neutral to revenue. Residential profit was a record $141 million up 21% with segment profit margin expanded 130 basis points to a record 21.5%. Segment profit was positively impacted by higher volume, favorable price and mix, sourcing and engineering led cost reductions and favorable warranty and other product costs.

Partial offsets included investments in research and development, information technology and other SG&A as well as investments in distribution expansion. Partial offsets also included higher commodity costs and unfavorable foreign exchange. Now turning to our commercial heating and cooling business, commercial revenue was a record $259 million up 2%.

Volume was up 4% and price and mix combined was down 1% with foreign exchange having a 1% negative impact. Commercial segment profit was $45 million down 6%. Segment profit margin was 17.3%, which was down 140 basis points.

Segment profit was impacted by unfavorable mix, higher commodity costs, investments in research and development, information technology and other SG&A. Partial offsets included higher volume, sourcing and engineering led cost reductions and favorable price.

In refrigeration, revenue in the second quarter was $190 million down 1%, volume was down 1% and price and mix combined was flat. Foreign exchange was neutral to revenue. From a regional perspective, Todd addressed revenue growth in constant currency. On a reported basis, Europe was down more than 20%. All other regions were up.

North America and Australia were up low single digits. Asia was up mid-single digits and South America was up mid-teens. Refrigeration segment profit was $22 million up 1%. Segment profit margin was 11.4% up 30 basis points. Segment profit was positively impacted by favorable price mix and sourcing and engineering led cost reductions.

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

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

Corporate expenses were flat in the second quarter at $24 million. Overall SG&A was $169 million in the second quarter or 15.3% of sales compared to 15.6% in the prior-year quarter. Cash from operations in the second quarter was $59 million compared to $76 million in the second quarter a year ago.

Capital spending was $18 million, flat with the prior year quarter. Free cash flow was $41 million compared to $58 million in the second quarter last year. Total debt was $1.19 billion at the end of second quarter and we ended June with a debt-to-EBITDA ratio of 2.1. Cash and cash equivalents were $61 million at the end of June.

Now before I turn over to Q&A, I'll review our outlook for 2017. Our underlying market assumption for 2017 essentially remains the same. For the industry overall, we expect North American residential HVAC shipments to be up mid-single digits.

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

Based on this underlying market environment, our targets for market share gains and the company's performance in the first half and outlook for the second half, we are raising the line of our revenue guidance from a range of 3.7% to a new range of 4.7%. We still expect a minimal impact from foreign exchange.

For GAAP EPS from continuing operations for the full year, we are narrowing our guidance from a range of $7.65 to $8.25 to a new range of $7.73 to $8.13. This incorporates the charges for special items taken this year and our latest guidance range for adjusted EPS.

We're raising the line of our guidance for adjusted EPS from continuing operations by $0.20. From a range of $7.55 to $8.15 to a new range of $7.75 to $8.15. Let me now run through the key points in our guidance assumptions and the puts and takes for 2017.

First, on the guidance points that are changing, we now expect commodity headwinds of $20 million in 2017 up from our prior guidance of $10 million. We are also updating our effective tax rate for 2017 from approximately 32% to a range of 31% to 32% on an adjusted basis for the full year.

Now for the guidance points that remain the same, we continue to expect $35 million in savings from our sourcing and engineering-led cost reduction programs. We continue to expect a $20 million benefit from price increases for the year. We expect $6 million in savings from our manufacturing operations in Mexico for actions already taken.

We expect residential mix to be a $5 million benefit for the year and we expect minimal impact from foreign exchange. A few other guidance points that are unchanged. Corporate expense is expected to be $85 million for the full year. We still expect net interest expense of about $32 million.

We continue to expect the weighted average diluted share count for the full year to be between 42 million to 43 million shares, which incorporates plans for a total of $250 million of stock repurchases for the full year. Capital expenditures are expected to be approximately $100 million and we are targeting free cash flow of $285 million for 2017.

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

[Operator instructions] First, we'll go to the line of Tim Wojs with Baird. Please go ahead..

Hey guys. Good morning. Nice job..

Hey Tim. Thank you..

So maybe just starting with the residential guidance, just given the good start to the year, any commentary on if that could have been nudged higher a little bit, just given how Q2 trends have been? And then maybe any commentary on how things have trended in July here? I think you have a little tougher comparison in the third quarter..

Our guide on res for the full year is always the market guide for volume is meant to reflect what we think the revenue is going to be. After a little bit of perceived weakness, I think in the first quarter by investors we had a really nice second quarter.

No days adjustments is up -- it was up 14% on revenue and the answer for Q3 is we're off to a nice start. I know there's been some concern from the weather comp of Q3 last year at least through the first three weeks of July, the business is trending well in residential and parenthetically I would say also in commercial and refrigeration.

So, we're off to a nice start.

There's still two and quarter months left in the quarter, but we're off to a nice start in July and then in the weather comps in fourth quarter actually swing back our way as we had a warm fourth quarter last year that created some headwind on a normalized basis for our residential -- on a year-over-year basis for our residential business.

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

Okay.

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

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

Okay.

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

What we'll do Tim is we're start doing that again second half of the year. There is still some messiness this quarter but starting third quarter, will start going back to the old updates on talking about above-minimum efficiency..

Okay. Great. Good luck on the rest of the year..

Okay. Thanks..

Our next question is from Gautam Khanna with Cowen and Company. Please go ahead..

Yes.

Good morning and wondered if you could first talk about where you think we are in the Resi replacement cycle? What the duration of it is? Obviously, it's been very strong and maybe comment on your thoughts on pent-up demand and the like as you move forward?.

Yeah. I've I think spoken about this in the past. I'll touch it again. I think there's multiple drivers of demand for our business. One, the first ones been over the last three or four years.

We think pent-up demand is being released from people who repair units during the financial crisis over a two or three-year period and those units re-breaking and coming back and have to be repaired and I think that's help drive the business over the last few years on the replacement side.

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

And then on top of that, which is in replacement markets, new construction, the momentum in new construction continues.

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

And so, we feel pretty confident on residential new construction over the next three to five years also. So, we think it's a market that's going to grow mid-single digits over the midterm which is three to five years..

Okay. And just a quick follow-up on the prior question on commodity costs, if it seems increasingly likely that the Section 323 -- 232 tariff goes ahead, would you consider buffering more inventory i.e.

system advance buys to kind of -- or are you just going to reset the pricing as soon as you face that headwind?.

I think a couple things.

I think the short answer is if we're going to have to drive both price and/or other cost containment actions and I think the longer answer is if we could buy a warehouse full of cheap steel today, we would, but our suppliers understand what's going on also and we have agreements with them and I think they're agreements, but they're not allowing us to stock up warehouses with low-cost steel..

Thanks a lot guys..

Thanks..

Next, we'll go to Steve Tusa with JPMorgan. Please go ahead..

Hey guys. Good morning..

Hey Steve..

I think it was the warranty help in Resi and then can you just give us a little more color on what product quality adjustment means?.

The residential adjustment impact to Resi was a couple million for the quarter, but what the adjustment was for Resi making sure I get the right page here in front of me, make sure I read this directly. We had a defective vendor-supplier component and you saw the charge of $3.4 million after tax.

The effect has been isolated the vendor supplying corrected components and reinstalling the corrected components. The after-tax charge relates to the total estimated repair cost of both labor and the product itself and we're working i.e.

negotiating with the vendor for a recovery of our total expenses and we'll see that in future quarters as we finalize the agreement with the supplier..

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

Is there -- why would something like this be labeled maybe you should ask this like two years ago when we did it, but why would someone like be labeled as a subtraction to the adjusted number there sometimes or are you guys like payments, like that you record in a positive way like reversals if you will have a reserve?.

The reversals, wherever we take the charge, we take the reversals. So, if we put a charge below the line and as I suggest, we're going to get reversals for it, we'll take that below the line too. So, we're trying to lead it one way or another. Again, we can talk -- we're being completely transparent.

So, it's all our disclosures and by the way, the gross margin number included it because gross margins are GAAP numbers. So, we're not trying to play games.

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

No. No. I am absolute positive, we're not saying that. I respect you guys a lot. I think you guys do business in a very high-quality way. So definitely not trying to infer that. Just trying to get details on the numbers. I think you guys were also supplying -- Goodman had some issues on some coils and they were sourcing them from you guys.

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

Yeah, I am not familiar with that. I may be not familiar, we supply coils to Goodman and our ADP business, we supplied coils distribution. So maybe some company-owned distribution. We sold some ADP coils, but I'm not aware of any quality problems..

Okay. Got it. And then just one more question on this commodity follow-up. So, have you already seen the adjustment in these prices for this tariff or whatever is coming in and ultimately how does this -- if you snap the line or you even think of where -- what your forecast is now, could you have adjusted obviously it up by $10 million on steel.

How does this play through into next year?.

Let me unbundle a little bit Steve. The $20 million is what we see now and looking forward on spot pricing and steel is the thing that we've come to the conclusion that the current spots -- future spots -- the futures is on the steel or sort of the right number to use. And so, I don't know how much of future tariffs are baked in the futures or not.

So, I guess I'm singling if steel goes up more, then we'll have to adjust more. We're hitting on the price that we said we're going to get for the year, which is $20 million. The issue is just commodity costs have gone up more.

As we think about 2008 and obviously in December we'll give more guidance on all this, but where steel and copper aluminum are as of today, it's clearly going to be a headwind next year and quite frankly a greater headwind than what we've had this year and we'll offset it with price and take appropriate cost containment actions as needed, but we're committed on the midterm -- the long-term guidance we gave of incremental drop-throughs of 30% and we'll adjust cost structure and our price to make sure that's the case..

Okay. Great. Thanks a lot for the color. I appreciate it..

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

Hey. Good morning, guys..

Good morning, Jeff..

Just on commercial HVAC, can you just talk about how you think mix and price cost play out versus some of the issues? It just sounds like it may be clarified.

It sounds like really the issue was timing and new construction and that normalizes in the second half?.

Yeah. I think you captured it, it's lots of details, because replacement was relatively strong. The issue was new construction. Our new construction was up. Mid-teens first quarter was down. Mid-teens second quarter in part driven by new construction can be very lumpy and the weather.

We had warm weather first quarter, which sort of pulled forward maybe a little bit of demand and we had some rainy weather in second quarter especial in the Southeast that may be pushed out a little bit demand. And then the other issue on margins was the national accounts that we did sell.

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

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

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

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

Is that a commercial question or broader HVAC question?.

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

Yeah on replacement, we don't see price wars. What we see is some other players getting involved in the market where other competitors other than carrier and also now emergency replacement, but we still continue to gain. They are down softness in commercial margins and revenue being only up 3%. The emergency replacement wasn't a driver of that.

It was other verticals as I spoke about. In terms of residential, no, I think you saw we had a very good quarter in residential. I think it'll look like we've gained -- look like because it's true that we've gained share first half of the year. Margins remain strong up 140 basis points.

And so, as I've often said at the edges of the Empire there's always skirmishes on price, but it doesn't appear to be any wholesale competitor decisions to compete with price in Resi..

Okay. Thanks a lot..

Thanks..

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

Hey guys. Good morning..

Hey Robert..

I wanted to ask about price mix in Resi. I think you said it was up one, given all that RNC strength was probably a mix headwind and I think you actually had a tough two-year stack on mix. There are actually some pretty good price embedded in their..

I think there's price. I also think there is -- in fact I know what it is. It's strong mix up in the product categories. We were asked earlier about giving a little bit more clarity to the portion of the product that's about minimum efficiency and we want to wait till third quarter to do that.

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

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

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

I see and all that strength in Resi, there has been some concern about pricing in general like rising price pressure in Resi, I think you've commented in the past that it's a little bit more concentrated there.

Is pricing a factor there, it just seems like really strong especially given starts and completes were up high single in the quarter?.

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

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

Got you. And maybe just lastly on refrigeration margins, I think first half you were up about 140. So, to get into your range implies second half, as about flattish.

Is that how we should be thinking about refrigeration margins?.

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

Got you. Thank you..

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

Thanks. Good morning. Hey, just my first question is really on the gross margin, that been up 90 Bps year-on-year in the first quarter was flat in the second quarter.

Am I right in thinking that was about -- if I am looking at that Delta year-on-year, you had maybe 50 Bps loss from the product adjustment costs and then maybe the balance was material costs a headwind.

Just if you could comment on why the gross margin was flat and also do you expect the gross margin to grow again year-on-year in Q3?.

I don't comment directly on Q3, I'll comment on second half year and yes, we expect gross margin to be up second half of the year. You did the math exactly on the note that I have in front of me.

The special product charge cost us about 50 basis points on the gross margin, and then there's lots of other puts and takes, but I think you probably like to grab on especially in commercial the price commodity gap that I spoke about was also a driver of the gross margins being flat, but the major ones, we developed 50 points without the special product charge..

Understood. Thank you and then residential, obviously a very, very strong second quarter. You've got very good line of sight on the distribution in the state of inventories.

Just wondered how you feel about residential inventory levels today in the channel both for your own product and of course if you think there's anything array or anomalous in the broader Resi HVAC industry in terms of current inventory levels in the U.S.?.

And again, I know you know all this Julian, but one, I don't know what the competitor distribution channels look like. Were they independent? Our is 80% company-owned and with our Lennox distribution we see the revenue when it leaves our distribution and so, we really don't have good last item.

In our residential business, we know about 10 days out what the revenue demand is going to be and so we can track order rates. In our allied business, which is the 20%, it does sell through independent distribution. Inventories are sort of at the right position.

Our independent distributors have seen our ability to meet at once demand and our flexibility around delivering and distributing the product out of our North American factories. And so quite frankly, they carry less inventory than they used to us and rely on us to support them and we're in a position to do..

Thanks a lot, and last very quick one, commercial margins, they were down I think 50 to 60 Bps year-on-year in the first half, the second half growing again. So, should we think the year is about flat to commercial margins..

Yes, that's how I would model it..

Great. Thank you..

Our next question is from Ryan Merkel with William Blair. Please go ahead..

Hey thanks. Just sticking with second-half margin improvement in commercial.

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

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

I see. Can you quantify the cost containment, just helps out or….

No, not yet. It continues to be things that we're doing on the factory and around discretionary spending and we continue to know -- we'll talk about that more in the third call -- third quarter call exactly what we're doing. But we understand we need to get our margin growth back on track in commercial are we're committed to doing that..

Okay. And then I wanted to ask about the Amazon risk to HVAC, as you probably know, there's good equipment available on Amazon through a reseller. I'm now getting emails from Amazon about home services HVAC needs.

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

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

And we always talk internally about 80% of the qualities of the installation and 20% of the quality to actual design and manufactured the product.

And so, I have no doubt Amazon can find dealers to install equipment and match them up with Goodman equipment, but the question is who are the dealers, what training do they have? Do they have Lennox pros that allows them to when they go in watch a video on how to install it? Have they gone through all the training classes and support that we provide them? So, I think it's very difficult for them to disrupt, not impossible, but it's not the same as buying a washer or a dryer because you had this huge installation and we continue to talk internally about all the things we have to do to make our dealers so much better than what you can get with ABC cooling that's matched up with Amazon a lot.

So, I would tell my mother not to buy a Goodman air-conditioner from Amazon steel no one knows who it is as if she wants it to work..

Well plus should would have to wait four to seven days to get it. Well thanks, appreciate it..

And we'll go to Jeff Sprague with Vertical Research. Please go ahead..

Thank you. Good morning, everyone..

Hey Jeff..

Lots of ground covered here, maybe just two other items.

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

No. We had some headwind in the second quarter that we didn't talk about, the order of magnitude is $1 million or $2 million on the cost side, but we absorbed it, offset it other ways, but we still really like our Mexican factory even with the swing in the peso..

Then on steel, I was wondering if you could give us just a little bit more of a frame of reference, obviously we don't know what your buy is at for 2017 and I don't expect you to tell us precisely, but if you're looking at where you're at in '17 versus where spot stands today. Spot is a good indication of where we're headed.

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

I think I just talked about how we buy, where we buy based on the prior quarter's CRU at a negotiated discount that we have with the mills and then it takes another month or two to work its way through our inventory to be able to see the cost.

And so, I would -- if I was building the model, I would tend to think about what steel pricing has moved on the spot based on five or six months prior period and then I think you can get the percentage move of the steel as opposed to our COGS..

Okay. That's helpful.

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

A portion of our business that sells into grocery, the largest part of that one business, display case business and as we've spoke about, we continue to focus on diversifying our customer base. I'll be honest with you, the Amazon thinks, it's really whole foods at the current point and we call on them.

We don't do a whole lot of business with them right now, but it's clearly someone we knock on the doors, the majority though of our refrigeration business in North America is our traditional Heat Craft Products Group business or HRP as we call internally.

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

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

All right. Thanks a lot..

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

Hi. Good morning, everyone. Just a couple quick one, so just back on the product issue with the vendor, was that stuff shipped in the last couple quarters or is -- have the longer tail to that..

It was shipped in the last couple quarters..

Okay. All right. And then price….

I am just looking around to make sure, I got that right. I am looking at Joe. Go ahead..

In the field, it seems like residential price stickiness at least relative to expectation is pretty good.

So, you mentioned commercial as being a little bit of a lag, how about refrigeration? Was there any negative impact in the quarter on price versus expectation limiting your ability to get price traction overall especially in commercial? And is Resi in your view better than expected on the price standpoint?.

No, I would say it's as expected. Our guide coming into the year was $20 million in price and that's still the guide. Quite frankly, I don't know if surprise is the right word, but certainly the change in the guide has been commodities going up not our ability to get price -- getting prices roughly what we thought..

Okay. All right.

And then on schools, how are you seeing school rebound for the year? I know that's pretty important and just broadly retail, I know it's been touched on a little bit, but when you look at the activity with new construction and what not, just purely timing of that, nothing in the market that wasn’t any concern on your end?.

No, first on schools, we were out mid-high single digits in the quarter and we were very good at schools. We have focused channel, our sales channel focused on it and have the right product also our VRF play strong there and as a driver of our VRF sales. And your second question was on new construction and commercial..

Yeah as it relates to, I know you talked about timing around first….

I read your notes when you publish all the architectural information and sort of the leading indicator. Nothing's changed. I think it's just the chunkiness of our business. I wouldn't read any macro driver into what happened. I think it's just the timing of individual customers..

Okay. Great. Thank you..

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

Hi. Good morning, guys..

Hey Josh..

Hey Todd. Just and maybe to come back on Ryan's comment earlier, hopefully they're not trying to get your mom to buy any Goodman equipment or regardless of the channel..

I like my dad does tear downs for me, so I would sometimes like him to buy a competitive equipment just to look at it..

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

The chatter is always heated up may be to compare your comments earlier on how has price trended this year? Do you think the industry needs to go for an off-cycle price increase or are we setting ourselves up for some of these hedges roll or spot rates normalize early in 2018 that the amount of price that everyone is going to need to get collectively all in one log it maybe a bit too big for the channel to want to take down or maybe start to see a bit more push back than normal?.

I think people can see what's coming and it's even where we're at now it's not going to be like it was in 2011 when commodities went up $40 million $50 million. So, I think the short answer is I don't think we're going to get a midseason price increase.

I think we're out where we're at and again it's hard to say we publicly talked about things but it's hard to -- we're offsetting commodities with price. We're just not doing better than commodities with price and as we roll into 2018 as I mentioned earlier, we'll measure where we're at.

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

And then just to follow more of a modeling nuance, so we don't have as we lap some of these quarters with the extra week along the way. Is there anything from a margin perspective we should keep in mind? It's easier to see it in the top line than maybe it is in the cost structure. Anything Joe that we should keep in mind in that regard..

No, I don't think there's any anomalies other than what we mentioned with just the different days that we adjust in the first and fourth quarter, but outside of that and updating steel guidance for the second half I think that's all I would suggest..

Okay. So, everything continues to drop through again 30% target incremental if all goes well..

Yeah absolutely plus or minus and then I think on the detrimental days that we have in fourth quarter, I would think about that volume drop into a more standard rate of 25%, the 23% incrementals refer to all the things we do on cost reduction and others and then the decremental on the fewer days, I would think about that dropping through 25%..

Got you. That's very helpful, thanks..

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

Hi guy. Obviously, a lot of ground covered here today.

Could you talk a little bit about the cadence if you could just April, May, June in terms of what you saw and what is presaged for third quarter from your standpoint in terms of what you saw obviously visibility is limited?.

Yeah, April, May and June in residential, all three were strong and there was quite frankly some concern as we went into June. I publicly had said April, May, we're up double digits and there were some concern, not concern, but we could read a weather map and we knew how hot it was last year going into June.

But June again turned out to be a strong month for us, so across the board it was strong. In commercial and refrigeration, most specifically on commercials as I talked about new construction being down that was in part driven by June and some of the wet weather we had.

And so, June was a little soft on deliveries as things got pushed out but the flipside of that is we entered the quarter with strong backlog and strong order rates and I use the word nice to talk about how Q3 is shaping up for commercial in July.

And so, I am trying to underline, look I get we had some softness in commercial in the second quarter, but we feel pretty good about the business moving forward..

Understood. A longer-term question and thankfully won't be about the industrial Internet of things your favorite topic. I guess talking about conceptually you're supply based in terms of some of your key components, whether it be compressors or motors.

Do you think there is just an opportunity here to do more value-based engineering, get better sources of supply, get better margin structurally over the next couple years, just given the changing landscape of who you can choose in terms of suppliers and vendors?.

Yeah, I think that's been an important part of our cost-reduction in the last two years and I think it certainly continues and so we're aggressively focused on whether it's designing -- making a change of the type of material that we use, aluminum rather than copper or taking costs out of our product by working with Asian suppliers or redesigning how the systems interact by using software.

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

And then last question is just on any thoughts in terms of the strategic environment for M&A and any areas of -- obviously in the past you talked about opportunities in refrigeration and diversification there in growth.

How would you typify the M&A environment from your perspective right now?.

Well I think we're pretty focused right now. If there is a large better -- there is a deal that we could consolidate the North America HVAC business and the North America unitary rooftop and/or residential, we would certainly want to play there.

There might be something in Europe with our European HVAC business to get some more ump there that we would do and then maybe something in refrigeration, but I still think we have our ways to go in refrigeration organically driving up margins before we would want to do another deal there..

Thanks for your time..

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

Good morning.

So, in refrigeration, could you provide some color on the weakness in Europe? Was it just the mid-teens comp from last year or was there something more structural?.

No, it's just -- it was not. There was lumpiness with customers. Our HVAC business was up by about the same percentage as our refrigeration business was down. It's just the timing of customers and to your point challenging comp..

Okay.

And then just in terms of CapEx how does that spend break down between maintenance versus both plus investment and how should we think about free cash conversion into next year and beyond?.

Yeah, I think starting with the CapEx maintenance is about 10% to 15% of the total spent and then free cash flow conversion we'll continue to target free cash to approximate spend income. So, I think it would be somewhere between 90% to 95% prospectively on that conversion rate..

Thank you..

Our next question is from Walter Liptak with Seaport Global. Please go ahead..

Hi thanks. Good morning, guys. My good question were taken. I was kind late in the call. So, about the comp for the third quarter and this was timing, I think July was really strong last year and then we went through those seasonal downturn or slowdown in the past.

And then maybe if you can just comment on how those comps look for you this year and then it seems like the new build was stronger than last year.

What was replacement like in the third quarter last year?.

The comps on Resi third quarter was warm last year and fourth quarter was also warm and so third quarter warmth was goodness last year and fourth quarter warmth was badness as it hurt our furnace season in November and December. I've said a couple times that we're off to a nice start in third quarter, which means our Resi business is doing well.

It's actually been warm in many parts of the country through the first three weeks of July.

So, I've visibility for the whole month and so we're going to have a nice July in residential in our other businesses and so that's going to come down to August and September, but if people worry about weather comps in July, they should be because we've got almost to the other side of July and we're tracking nicely..

Okay.

Was the new build strong last year or are we seeing a better new build market for Resi this year?.

We had strength last year, but from memory, I think we were 10% or so last year in new construction and obviously given what we performed here in second quarter, we're up year-over-year to the first half of the year in new construction..

Okay. All right. Great. Thank you, guys..

Great. Thanks..

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

A few points to leave everybody with. We had strong growth in the second quarter certainly all-time high. Set new all-time highs for revenue and profit. The third quarter is off to a nice start and we look forward to continue momentum in the second half for a year of record revenue and profit for Lennox International.

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

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect..