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

Tim Wojs - Baird Gautam Khanna - Cohen & Company Jeff Hammon - KeyBanc Rich Kwas - Wells Fargo Jeff Sprague - Vertical Research Robert Barry - Susquehanna Ryan Merkel - William Blair Julian Mitchell - Credit Suisse Robert McCarthy - Stifel Walter Liptak - Seaport Global Josh Pokrzywinski - Wolf Research Steve Tusa - JPMorgan.

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Third Quarter 2017 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded. And I would now like to turn the conference over to Steve Harrison, Vice President of Investor Relations. Please go ahead..

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

To give everyone time to ask questions during the Q&A, please limit yourself to a couple of questions or follow-ups and requeue 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 a direct link to the webcast of today's conference call on our website at www.lennoxinternational.com. The webcast will be archived on that site for replay.

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

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

Before I turn the call over to Todd, I would like to announce the date of our annual investment community meeting. The event will be held the morning of Wednesday, December 13, in New York City. Please mark your calendars. Invitations and more details will follow. The meeting will also be webcast.

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

Thanks, Steve. Good morning, everyone, and thank you for joining us. Lennox International posted a record third quarter for revenue, total segment profit and EPS but it also a quarter where growth and margin performance were materially impacted by significantly cooler weather than a year ago by the hurricanes that hit Texas and Florida.

Nationally, cooling degree days were down every month in the quarter, including more than 20% in both August and September. Overall, for the third quarter, cooling degree days were down 16% from the prior year and the key swing regions of the upper Midwest and northeast were down more than 30%.

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

These dynamics most directly impacted our Residential replacement, Commercial emergency replacement and refrigeration wholesale businesses to weigh down our growth and margin performance for the quarter. Overall for the company, revenue was a third quarter record 1.05 billion, up 3% at constant currency.

On a GAAP basis, operating income was down 1% to 155 million. GAAP EPS from continuing operations was up 5% to a third quarter record $2.45. On an adjusted basis, total segment profit rose 2% to the third quarter record of 161 million. Total segment margin was 15.3%, up 30 basis points from the record third quarter level a year ago.

Adjusted EPS from continuing operations rose 9% to a third quarter record $2.53. Turning to the key points on our business segments for the third quarter. In Residential, revenue and profit hit new third quarter highs. Revenue was up 3% on high single digit growth in new construction and low single digit growth in replacement business.

Segment margin was 19.4%, up 30 basis points from the record third quarter level of a year ago. Residential profit rose 2%. On the Operational front, we continued to invest in R&D and IT to support innovative new products in the future growth of the business, as well as investments to further expand our distribution footprint.

We ended the quarter with a total of 230 Lennox Parts Plus starts, up 14 stores in the quarter. We continue to focus on both opening new stores and leveraging our existing investments by driving same-store sales growth.

In Manufacturing, we are on track to realize the $6 million of savings this year in our Mexico operation and we expect a similar level of incremental savings as we look ahead to 2018 from productivity initiatives in our U.S. operations. Turning to our Commercial business, revenue and profit hit new high marks for any quarter.

Commercial revenue was up 6% at constant currency. Segment margin was 18.6%, up 90 basis points from the record quarter a year ago. Commercial profit was up 2%. The commercial margin decline in the quarter was impacted by two factors.

First, we had large orders from certain national account customers that were a lower product mix that shipped in the quarter. And the second factor was the year-over-year change in the timing of some expenses. Pricing commodities were balanced in the quarter.

We continue to expect commercial segment margin be slightly up in the second half in total over the prior year period. Looking at commercial revenue drivers in the third quarter at constant currency, North America equipment revenue was up high single digits, replacement revenue was up low double-digits.

The plan replacement revenue up 20%, and emergency replacement approximately flat. New construction revenue was up mid single digits. Cutting the business another way, national account equipment revenue was up nearly 20% and new national account revenue was up low single digits.

Looking at new national account equipment business, Lennox won 11 new customers in the third quarter for a total of 37 year-to-date. New customers in the third quarter included healthcare, facilities, restaurants, retailers, and construction and real estate firms.

On the national account service side of the business, revenue was up mid-teens in the second quarter. In Europe, commercial HVAC revenue was down low double-digits at constant currency. In Refrigeration, revenue was up 2% at constant currency.

From a regional perspective at constant currency, North America and Australia were flat, South America was up low single digits, Europe was up low double digits, and Asia was up more than 25%. Refrigeration margin was down 190 basis points to 10.4% and segment profit declined 13%.

The margin decline was driven by a negative mix from the weather impacts on our North America business, which is our most profitable business. We also had productivity issues in several of our key factories. We are addressing this and are well on the way to having these behind us.

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

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

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

Thank you, Todd. Good morning everyone. I’ll provide some additional comments and financial details on the business segments for the quarter, starting with residential heating and cooling. Residential revenue was a third quarter record $591 million, up 3%. Volume was up 3%. Pricing mix combined was flat with price up 1% and mix down 1%.

Foreign exchange was neutral to revenue. Residential profit was a third quarter record $115 million, up 2%. Segment margin was down 30 basis points to 19.4%. Segment profit was positively impacted by higher volume, favorable price, sourcing and engineering-led cost reductions, and foreign exchange.

Offsets included higher commodity and other product costs, unfavorable mix, investments in research and development, information technology, and other SG&A, as well as investments in distribution expansion. Now, turning to our Commercial Heating and Cooling business. Commercial revenue was a record $269 million, up 7%. Volume was up 5%.

Price and mix combined was up 1%, with price up and mix flat. Foreign exchange had a positive 1% impact. Commercial segment profit was a record $50 million, up 2%. Segment profit margin was 18.6%, down 90 basis points.

Segment profit was positively impacted by higher volume, favorable price, sourcing and engineering-led cost reductions, lower SG&A expense, and favorable foreign exchange. Offsets included lower mix, higher commodity costs, higher freight and distribution expenses, and the timing of other expenses.

In Refrigeration, revenue in the third quarter was $192 million, up 3%. Volume was up 2%. And price and mix combined was flat. Foreign exchange had a positive 1% impact on revenue. From a regional perspective, Todd addressed revenue growth in constant currency. On a reported basis, North America was flat.

South America and Australia were both up mid single digits. Europe was up mid teens, and Asia was up more than 25%. Refrigeration segment profit was $20 million, down 13%. Segment margin was 10.4%, down 190 basis points.

Segment profit was impacted by unfavorable mix, factory productivity, higher commodity costs, higher freight and distribution expenses, and investments in research and development, information technology, and other SG&A. Partial offsets include volume in sourcing and engineering-led cost reductions.

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

Also excluded was a benefit of $1.5 million for excess tax benefits from share-based compensation. Corporate expenses were down 13% in the third quarter to $24 million. Overall SG&A was $159 million in the third quarter, or 15.1% of sales, compared to 15.5% in the prior year quarter.

Cash from operations in the third quarter was $177 million, up from $152 million in the third quarter a year ago. Capital spending was $17 million, compared to $18 million in the prior year quarter. Free cash flow was $160 million, up from approximately $134 million in the third quarter last year.

Total debt was $1.12 billion at the end of the quarter, and we ended September with a debt to EBITDA ratio of 2.0. Cash and cash equivalents $61 million at the end of the quarter. Before I turn it over to Q&A, I’ll review our outlook for 2017 and provide a few thoughts on 2018.

For the industry overall, we expect North American Residential HVAC shipments to be up at the lower end of the mid-single digit range. We expect North America Commercial unitary shipments to be up low single digits. And we expect North America Refrigeration shipments to be up low single digits.

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

For GAAP EPS for continuing operations for the full year, we are updating our guidance from a range of $7.73 to $8.13 to a new range of $7.67 to $7.97. This incorporates the charges for special items taken this year and our latest guidance range for our adjusted EPS.

We are updating guidance for adjusted EPS from continuing operations from a range of $7.75 to $8.15 to a new range of $7.75 to $8.05. Now let me run through the key points of guidance assumptions and the puts and takes for 2017.

First, on the guidance points that are changing, we now expect a $5 million benefit from foreign exchange for 2017 versus our prior guidance for a neutral impact. We now expect Residential mix to be flat this year instead of a $5 million benefit given the faster growth in Residential new construction and the replacement business.

Now for the guidance points that remain the same. We continue to expect $35 million in savings from our sourcing an engineering led cost reduction programs. We are on track for $6 million in savings from our manufacturing operations in Mexico from actions already taken.

We continue to expect $20 million of headwind from higher commodity cost this year, offset by $20 million of price this year. As an aside, looking ahead for next year, 2018, we continue to expect approximately $40 million of headwind from higher commodity costs, offset by $40 million of price, so similar of a year of 2011 in that regard.

Now back to 2017 for a few other guidance points that remain unchanged. We continue to expect an effective tax rate between 31% to 32% on an adjusted basis for the full year. Corporate expense is still expected to be approximately $85 million for the full year. We still expect net interest expense of about $32 million.

We continue to expect the weighted average diluted share count for the full year to be between 42 million shares to 43 million shares. Capital expenditures are expected to be approximately $100 million. And we are targeting free cash flow of $285 million for 2017. And with that, let's go to Q&A..

Our first question comes from the line of Tim Wojs of Baird. Your line is open..

I guess maybe just the first question I have is, if you could piece out maybe the mix impact on margins in residential for the quarter and then I know this is kind of a pretty tough question but what do you think the hurricane might have cost you in the third quarter?.

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

And the higher margin replacement - the math I would look at was the higher margin replacement business was only up 2% in Q3, while our new construction business was up high single digits, and as we discussed, the replacement growth was really tampered down by the cool weather in Q3.

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

So we're selling more premium product than we did the prior year. In terms of the impact of the hurricanes, I'll be honest with you, Tim. We've had a lot of conversation about this internally. It's really hard to quantify. There's lots of moving pieces.

But I think one point that I would point to is that our residential replacement business over the last six quarters has, on average, grown about 8% year-over-year. In Q3, the replacement business was only up 2%.

And there was no change except cooler weather and the hurricanes and so I think that's sort of an order of magnitude of what we were impacted either by cooler weather, by the hurricanes, and we'll see some of that bounce back in future quarters. .

And then just on 2018, just the commentary on the inflation cost and pricing, that’s a bigger hurdle from a incremental margin perspective, so just given that you have a 30% incremental margin target on an intermediate basis, what are some of the other things outside of sourcing, maybe some of the productivity, within North America that can help you get back to that 30% incremental margin in 2018?.

Maybe I'll walk through sort of a preliminary bridge, if you will, from 2017 to 2018, and again, as you know, Tim, we'll be providing detailed guidance on 2018 at our annual analyst day in mid December. But a couple of points I'd make is our end markets have been growing in low mid to single digit range.

And while there's always risk, as we saw in Q3 from weather, we don't see much of that changing as we go into 2018. We think the momentum continues for all of the reasons you've heard us talking about. In addition, we continue to gain share in our HVAC business from North America.

We're about up a little over half a point of market share, and that's where we've been the last four or five years. I think continues. We're focused, as you suggested, on a 30% incremental. And we're committing to doing that next year.

And sort of the moving pieces to me are we expect another 30 to 40 million of incremental savings from sourcing and engineered-led cost reduction. We've talked about -- while we're not giving Mexico savings next year, we're confident we can get similar 5 million to 10 million of savings from productivity initiatives in our U.S.

factories, both by automation and other lean techniques. As you talked about for Commodities, we expect about a 40 million headwind. The phrase I've used before is about twice of what we've had this year. So it's plus or minus 40 million where we're confident we're going to be able to offset that with, order of magnitude 40 million of price.

I think sort of the newer story from the last couple of years, and I've talked about this publicly the last few months, is we're targeting SG&A productivity, and over the last few years as we've had a windfall of both commodities and price, we've been able to accelerate SG&A spending in IT and R&D on some big strategic investments.

We've had SG&A as a percent grow in line with revenue growth rate percentage. And while we think in 2018 that it will grow more in line with half, or maybe even a third of the revenue growth. And so while we're still going to continue to invest in SG&A, the growth rate will slow down.

And we think that helps the SG&A productivity that we’ll get with help ensure that we’ll be able to get to 30% incrementals. So overall, economic conditions remain solid as we go into 2018 and we expect another record year. And we're targeting 30% incrementals. .

Our next question comes from Gautam Khanna of Cohen & Company. Your line is open. .

Todd, I was wondering if you could expand upon how you're trying to grow things for same store sales of the PartsPlus businesses? What specifically are you doing to kind of accelerate growth at some of your more mature stores?.

We'll talk about it more when we -- at the December analyst day. But sort of high level, I think about it this way, we put -- the name, historically, has been a bit of a misnomer. They’re called PartsPlus. But they were really put in place with the focus of growing equipment sales, and they've done a great job of doing that.

But we now have these mature stores in place. And if you look at our mix of parts and supplies -- so, the revenue that we sell as a residential business, our parts and supplies mix is about 25%, and the other 75% is equipment sales. You look at a Watts Co, sort of an industry leading distributor, they're more 30%, maybe even 35% parts and supplies.

And so we think it's a big opportunity to grow our parts and supplies business and flow it through this fixed cost asset, the stores that we have. And so we've taken aggressive initiative, and we'll share again some of the -- more of the details in December. But focusing on targeting what SKUs we want to carry, i.e.

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

And then the third piece is around inventory and logistics management to make sure we're inventorying the rights parts and pieces on-site to be able to meet demand. So we think there's a big opportunity there. .

And one follow-up. At Refrigeration, when do you anticipate some of the better economics on one of your large customer contracts will start to benefit your margins? I’m specifically referring to Wal-Mart, of course. .

We continue to work through with the Wal-Mart business. We recently want, and others, our competitors want businesses on the display cases. We're going through a quoting process with them on the system part of the business.

And longer term, our goal within our Kysor/Warren businesses to grow the margins not only from making the Wal-Mart business more profitable but quite frankly diversifying our customer base. We think we've done a pretty good job at taking costs out of the factory. We continue to design costs.

So higher portion material cost reduction as a percentage of revenue is coming out of KW than maybe any other business that we have. But it's also focusing quite frankly on winning new customers and our team’s focused on doing that. .

And next we'll go to the line of Jeff Hammon of KeyBanc. Your line is open. .

On Refrigeration, did you mention factory productivity issues, just what's going on there? It seems like the margins have stepped back a little bit after some period of progress..

Let me broaden the answer. I mean, we saw margins down 190 basis points after being up the last five or six quarters. There are two major drivers, and the first one’s a primary one, which was negative mix from the weather impact on our North America businesses.

Our most profitable business in all of Refrigeration is our North American Heatcraft Refrigeration Product group, we call it HRP internally, which is the non-Kysor/Warren part of the business. And more than 50% of that business is sold through distributors.

It's a flow business, sort of demand business that is tied to economic conditions, but also quite frankly tied to weather and what’s happening in the market place. Our Heatcraft business over the last six quarters on average had a growth of about 4% per quarter, and in Q3 we saw a 2% decline.

And while there were some other moving pieces on demand side, we think weather had a major impact. So this very highly profitable business we have being down 2% rather than being up 4% as it has over the last six quarters had an impact, so it mixed down.

And then the other is yes, I did mention on the call that we had some productivity issue on several of our key factories, in Europe and one of our Heatcraft factories in North America. We're addressing this and we're well on our way to having those behind us. The issues were material flow issues and labor productivity.

We continue to expect Refrigeration margins this year to be flat to up 50 basis points. I think prior guide was 50 basis points. We may think there’ll be a little pressure on that. But we continue to focus on reaching the 12% to 14% segment margin by 2019.

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

And then just on commercial heating and cooling, the 20% growth in national accounts, any positive lumpiness or timing there? Or is that just some key wins? And then I think you said emergency replacement was flat. Is that kind of weather or maybe a little color there? Thanks..

We think emergency replacement was clearly weather, because we've been high single digits, close to 10% the last couple of years. And so we think it’s clearly weather driven. On the national accounts, it's always a combination of both, so last quarter we had revenue that was slower growth than what we've had and then this quarter we had strong growth.

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

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

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

Just on commodities, the 40 million for next year, what kind of lag impact does that have as we think about extending into 2019? So if you snapped the core today, does that fully get you up to speed with regards to the cost headwind or because there's some smoothing that happens with the hedging that there's still some negative impact that creeps into 2019.

But just kind of broad thoughts around that?.

I mean, I'll give a narrow answer and then I can broaden it with some rambling comments you can help model yourself. The short answer is I think it really depends what happens second half of the year, and sort of how quickly it moves.

So as you know this, Rich, but for others on the call, 65% to 70% of our COGS is material and 25% to 30% of that are commodities, and on steel we buy on a prior quarter market pricing with a discount from the mills, and then copper and aluminum we hedge, about half of it to 12 months out.

And as we look at 2018 on copper and aluminum, we're order of magnitude about 50% hedged already. So as we look at 2018, we're 50% hedged. And so the flipside is there's 50% on the spot market.

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

So again we think order of magnitude it's going to be 40 next year and that's betting a little bit on taking the future curves of what we think copper and aluminum is going to do second half of the year. And it sort of depends how it moves second half. We'll have impact as we go into 2019. .

And then in terms of the replacement versus new construction piece, do we, from a mix standpoint, just big picture, do we think that replacement incremental margins being north of 30 and new construction incremental margins under 30, is that -- like, if I were to say 25 for new construction, 35 for replacement, am I far off in terms of trying to gauge the mix impact here in this quarter?.

No. You're close..

And then last quick one, just start to October, I mean, the first part of October was warmer than normal against year ago period, second week’s been better, so I mean, what are you seeing so far? I know it's been early, I know most of the heating this season’s yet to come but just any quick thoughts. .

No, I mean, I think it's early, as you suggested, but we're off to a solid start, and as you said, and for others on the call who don't know our business as well, is we're now rooting for cool weather, it needs to turn cool, and so if we want it to get cool in the northeast and midwest. December’s always an important month.

A couple score keeping things to remember was last year was a warmer than normal Q4, which led to a lower mix of furnaces. So if weather is more normalized this year, that's going to sort of be a good tailwind for us. The other housekeeping reminder is while we had 6% more days in Q1 because of the calendar, we're going to have 6% fewer days in Q4.

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

Next we have the line of Jeff Sprague of Vertical Research. Your line is open..

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

Is revenue caught up in the quarter on price?.

In Residential, just looking at my details, almost. We’re a little short on price but again, I think that had to do with we were within a million or two of offsetting commodities. In prior quarters, we had. We think that had as much to do with the mix of business and ability to get price with builders versus the flow of business.

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

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

Does stuff just get pushed to next season or is there kind of a catch-up play here in AC even though we're going off-season? Just how do you see that playing out?.

Not totally sure, and that's why I'm being a little opaque on the guide, because quite honestly we're not sure internally.

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

And so we're making sure we have lots of parts and supplies there to be able to meet the demand. Being longer term, people will need to replace units. And that may be more in 2018 and maybe bleeding into 2019. And again, we'll have equipment in market to be able to do it.

I think right now in both these markets we've seen some spike up in parts and supplies, not much movement in equipment yet, but that's to be expected because, quite frankly, they're still sorting things out. .

And then just finally on Refr, Todd, it's clear that you're not happy with the performance, and you made some management changes there. It is kind of surprising to hear productivity issues at several plants, like in one quarter.

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

I wouldn't say it's coincidental. I also wouldn't sort of get hung up on a systemic issue.

When I look at the 190 basis points movement in March and the major driver we think was the mix of our North American business, but I also wanted to be fully transparent that we did have issues and, again, it has to do, we have a very sophisticated engineered to order product line, both in the U.S.

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

Next we have the line of Robert Barry of Susquehanna. Your line is open. .

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

Is that related to the operational issues or end market?.

That's a good follow-up. A little bit of operational issues. We had trouble making deliveries. And we think the end market’s probably flat and there's just a chunkiness year-over-year of customer orders. We had some big orders in the Middle East last year that didn't repeat themselves this year.

And that's not a call on the market, that's just a reflection of our business. .

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

I think you said new construction was up mid-single, but what do you think the end markets did? And how are you thinking about the outlook there?.

We continue to be steady as she goes. And you know this, Robert, but I'll say it for others is where we play in Commercial is the unitary space, which is buildings three stories and below. We don't play in large Institutional. We don't play in high rise office buildings. We don't play in high rise residential buildings.

And so the verticals we play in continue to bubble and percolate. Retail, K-12 education, entertainments, fast food, and those continue to perk along. And so we see steady growth in Commercial and we call for market to be up low single digit. We think that's probably where it's going to be.

And that's order of magnitude as we sit now, going into 2018, what we think it's going to look like. So, I understand all the calls about concern about commercial markets. We're quite frankly not seeing it. .

And just to clarify one thing you said earlier about bringing the growth down in SG&A.

That's happening regardless of what price cost does, is that right?.

Correct. Yes, for two reasons. One is we've already, as I said, strategically, we pull forward investments. Now it's the right thing to do. Second is you can't wait for commodities to come in. So, you got to take the right sizing actions now.

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

Next we have the line of Ryan Merkel of William Blair. Your line is open..

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

So, Todd, any guess at how many residential units the industry could see from the hurricane clean up in 2018?.

No. I mean, again, if I had a good perspective and a number that had a reasonable error margin around, then I'd go for it. But it's really hard to quantify and so many moving pieces around repair versus replace versus what all the impact was. And so I've seen, obviously, some of the forecasts that are out there publicly.

The thing I'm confident of is it will have impact. I'm confident that the weather will bounce back in Residential, and the fact that we were up 8% in Replacement the last six quarters in resi and we're only up 2% in Q3, that's both weather and hurricanes and we'll see that come back. .

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

Is this something you expect and is there any margin opportunity for you or does the rising cost offset the price?.

We'll see. And we'll probably talk about that a little bit more in December, but that's certainly too the minimum efficiency regulatory requirements are going up in commercial equipment and sort of from a technical viewpoint, we have all of that in position. Costs are going up for us and our competitors, and we'll certainly pass that on.

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

I don't think that will be a material call out, that we'd always be disappointed if we launched sort of a new product and didn't either keep margin percentages or have them go up..

Next we have the line of Julian Mitchell of Credit Suisse. Your line is open..

Maybe just firstly on the balance sheet, in terms of capital deployment, you sort of spent what you thought on buybacks in the second half already in Q3. Your share count guide for the year is unchanged.

So maybe any updates on buyback planning or any other use of cash?.

At this point, I think it's steady as she goes. We plan on $250 million of share repurchases in 2017. We've completed that or will complete that, quite frankly, in the early part of the fourth quarter. We still expect to spend about $100 million in CapEx to support business initiatives going forward.

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

And then your gross margins, obviously down 90 bps or so in the third quarter, some onetime factors within that.

But when you’re looking at that specific rate over next six or twelve months, should we be expecting gross margins to be flat to down, offset by SG&A coming in a lot, or do you think the gross margins should be able to show a recovery fairly soon?.

I think the gross margins will show recovery. I think what we saw in third quarter, not to continue to flog this answer, but the weather impacted mix, and when mix is down in our residential business in our Refrigeration business, that impacts our gross margins. So SG&A productivity is going to help buffer or help insure we get to 30% incrementals.

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

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

Any specific changes or new product rollouts that you'd want to highlight or this is just normal course of business activity?.

This is normal course of business. So we tend to roll out our products in first quarter with our marketplace. And so it's the areas that you know we're investing, controls, energy efficient product, and all our alternate refrigerants and so all of those programs we continue to make investments. .

Next we have the line of Robert McCarthy of Stifel. Your line is open. .

Thanks for squeezing me in. No pun intended. In any event, a couple of questions.

I guess one on did you see any difference -- and I know it's tough looking at all of the distorted impacts of the hurricanes -- but any difference in kind of trend line sales between kind of quarter to date from July through August through the hurricanes to get a better sense of kind of what the distorted impact’s going to be? I mean, you did cite the 600 basis points I think break in trend line.

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

In my comments, and in the script tried to lump the cooler weather and hurricanes together in part because it's hard to disaggregate the effects. And so when we look at our demand for replacement business I guess pre-hurricane we were having cool weather and then the weather warmed up some and then we had the hurricane effect.

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

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

Are you seeing any concerns around pricing in the marketplace?.

I think about it this way. We're committed to getting the price to offset commodities. Our industry has a track record of the entire industry doing it, our competitors have the same cost structure we have. They have the same commodity inflation we have.

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

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

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

I think the only thing I know is that we -- I think value can be created through a combination, traditional industry consolidating synergies, if you will, or margin creation. We think we're in a great position to do it. Other would have to decide that they don’t want to be in the business.

It certainly looks like, right now, there's an environment where industrial conglomerates are getting help on what businesses they should be in. And if someone gets some help that they want to exit some of these businesses, we'd love to talk to them. .

Next we have the line of Walter Liptak of Seaport Global. Your line is open..

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

Is it a stronger part of your business or something that you need to work on? How do you feel about the channel?.

We love our own distributions channel and we think our PartsPlus strategy is a very good one and all of the investments we're making, both in the Southeast and the Southwest and across the country continue to pay dividends. I mean, clearly someone like Watts is stronger in Florida than what we are and that's just been a historical fact.

But I think if you look at where we were five, six years ago to where we are now, and if you look at both market share and physical distribution, we've made some nice gains. And so we continue to focus on those markets as well as other markets around the country. .

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

I don't know off the top of my head. We can get you that answer. But, again, it’s -- the way we think about it, at least the way, yeah, we think about it is we’re not trying to win in the Southeast. We're trying to pick those store openings that create the most value for us, and that's how we prioritize the investments.

And so if we already have a high share someplace, but we've identified customers, we put stores in, we’ll have really high share, then that's where we'll put the stores. So we’re going where the opportunity is and thinking about it that way. .

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

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

We have strong relationships with the top 20 national builders, and especially the top ten, and we spent time with them. We have visibility and they give us visibility about land they own and what their forecasts are. But it's sort of like our national account business.

They give us guidance, they give us visibility, but if the macroeconomic environment changes, they react to it. So, right now, when we talk to our big builder guys, it’s steady as she goes. We guided for new construction, our business be up 10% this year, might be up a little bit more than that.

And as we think about 2018, we're sort of thinking something similar. But if the interest rates were to spike up or something happen to the economy, they can certainly slow down on their building. .

Next we have the line of Josh Pokrzywinski of Wolf Research. Your line is open..

Just a follow-up on that 40 million of price cost, Todd. I think from the first time you quoted that number, maybe it had a pretty big range around it. Copper’s had another, I don't know, maybe 10%, 15% move, something like that.

Are you just abnormally hedged into 2018 at this point? Or is that a number that could have some fluidity, if copper stays kind of well above $3 here?.

Where we're at now and again, we've - our guys, including me, just decided 40 was easier than me constantly saying order of magnitude twice of what we have this year. But it is order of magnitude twice of what we have this year, and where copper sits today, we think 40ish is the right number.

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

And then just the part of the equation that I guess has historically gone kind of unmentioned and not unnoticed, but hard to quantify is on the purchase component side. Clearly, your suppliers are going to want a bit more price and maybe contractually are obligated to get some.

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

But is that a net number or a gross number? And when we think about that $40 million in material sourcing and value engineering number, is that really something higher and then it comes down based on supplier price increases? Just trying to get that other pocket of the equation that we can't track on Bloomberg directly..

When we quote an MCR number, the 30 million to 40 million, this year 35 million, its bottom line net impact. And so we can literally point to a P&L and see it internally. And so short answer is we get price increases from time to time, but we have to outrun those and sort of the net number is 30 to 40.

We used to joke when I was at UTC, if you do it the other way, you can have cost reduction equal to GDP of small countries and so you have to be very focused about how you measure this. And this is a net number we can see it in the P&L. It's after all price increases..

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

Especially in Florida, maybe less so in Houston, but in Florida we've seen some pickup in parts and supplies..

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

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

Our last question comes from the line of Steve Tusa of JPMorgan. Your line is open..

The industry, what do you think the industry actually did in 3Q and in Resi on a unit basis? I didn’t -- I'm sorry, I hopped on a little late. I didn't catch that. And then what do you think on a unit basis you're kind of -- is that number kind of a same store basis? I know you guys open stores every year.

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

Honest answer is I don't know just on third quarter. I'll come back to that in a second. What I said on the call was on a full year-to-date basis, our HVAC businesses were half a point or slightly above in share which is consistent with what we've done the last four or five years.

As you know, given some people have independent distribution and the timing of loading and unloading, any given quarter could be skewed So if you look at HRI data, it's that way. If you look at Hardi data, it's sell-through. And so that's different.

So I -- when we -- and again, we're biased, but when we talk to our guys on the street, we think we had a pretty good quarter, that only being to have add-on replacement be up 2% in Residential, new construction be up high single digits, we think we did pretty well.

But the numbers may say something different just given the timing of loading distribution..

I've also heard from the channel that others are kind of going about this kind of distribution storefront kind of build out, that some of your peers have started to kind of initiate similar investments.

Are you seeing that out there? Particularly, I know you're not going to talk about specific brands but I particularly heard that the train is starting to kind of pursue that strategy.

Has there been a bit of a change there from competitors reacting to the success you're having there? I guess you guys differentiate because you definitely own more of your distribution, but just curious if you're seeing anything on the ground from competitors with a response..

No, I mean, we've certainly heard from public utterances. JCI talk about it and to a lesser degree train talk about it. But, again, to your point, we have a big advantage because we own distribution.

And look, we've been clear from the beginning we didn't invent this concept, right? I mean, Carrier’s had total on stores for 50 years or 40 years in the field. And so when they own their own distribution. And so we're doing what others have already done. And I so if they want to build out stores, fine. So will we.

But the only caveat I would give to them is I think building out a store strategy is a five to ten year strategy that you've got to be committed to because it takes a while to get the virtual cycle sort of headed in the right direction like we do. And so we now have a machine and we just keep marching with it.

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

Operator, I think that's all the Q&A. So, I want to thank everyone for joining us on the call. My closing comments are what I said in the script, the company is well positioned to close out a record year for revenue margin and EPS and to drive strong growth and profitability over the coming year. Again thanks for joining us today.

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

New York Palace..

New York Palace. I'll put a flag in for them on the morning of December 13 for our annual investor community meeting. Thanks, everybody..

Ladies and gentlemen, that now concludes the conference for this morning. We do thank you very much for your participation and for using our AT&T executive teleconference service. You may now disconnect..