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Executives

Todd Bluedorn - Chief Executive Officer

Susan Carter - Chief Financial Officer

Steve Harrison - Vice President of Investor Relations

Analysts

Jeff Hammond - KeyBanc Capital Markets

Curt Woodworth - JP Morgan

Keith Hughes - Suntrust

Michael Coleman - Sterne, Agee

Lennox International, Inc. (LII) Q3 2008 Earnings Call October 22, 2008 6:00 AM ET

Operator

Ladies and gentleman, thank you for standing by. Welcome to the Lennox International Q3 2008 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 call is being recorded.

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

Steve Harrison - Vice President of Investor Relations

Good morning. Thank you for joining us for this review of Lennox International's financial performance for the third quarter of 2008. I am here today with Todd Bluedorn, our CEO, and Sue Carter, our CFO. Todd will review highlights for the quarter and Sue will take you through the company's financial performance.

In the earnings release we issued this morning, we have included the necessary reconciliation of the financial metrics that will be discussed to GAAP measures. You can find a direct link to the webcast of today's conference call on our corporate website at www.lennoxinternational.com. We will archive the webcast on that site and make it available for replay.

I'd 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 forward-looking statements are subject to risks and uncertainties. A list of these risks and uncertainties is included in our recent 10-K filing with the SEC, and includes the impact of higher raw material prices, our ability to implement price increases for our products and services, the impact of unfavorable weather and the possibility that a decline in new construction activity will depress the demand for our products and services. These risks and uncertainties could cause our actual results to differ materially from those we express to you today.

Before I turn the call over to Todd, I would also like to announce the date of our Annual Investment Community Meeting for analyst and institutional investors. It will be held the morning of December 17 in New York. Invitations in more details will follow. The event will also be webcast.

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

Todd Bluedorn - Chief Executive Officer

Thanks Steve. Good morning and thank you for joining us. Strong operational execution by Lennox offset market headwinds in the third quarter. The company had strong cash generation and solid earnings performance, including record EPS on both an adjusted and GAAP basis. Total company revenue for the quarter was 974 million, 5% below the prior year. EBIT loss was 10.5%, up 30 basis points. EPS on an adjusted basis was $1.10, up 17%. On a GAAP basis, EPS was $0.96, up 9%. Revenue was impacted by 9% decline in volume. Although volume was down across all our segments in the third quarter, we began to see the benefit of our mid year price increases across every segment.

Lennox continues to win in the marketplace with its innovative and high energy efficiency products. Let me give you a few examples. In residential, our Lennox high efficiency products of 14C and above were up about 10 percentage points from year ago to approximately 30% of shipments. We have also announced an innovative product called SunSource, which is the industry’s first integrated solar assisted residential heating and cooling system. This product will be available to the public in the first quarter of 2009.

In our commercial business, I am pleased to say that we continue to win major new national accounts. In the first nine months of this year, we have signed up 23 new national accounts. This is on top of the 29 we signed up last year for a total of 52 in less than two years. The energy efficiency gain from our new unitary roof top systems such a Strategos is a major reason for this success that presents a compelling opportunity for these new customers.

Like our commercial business, our refrigeration business continues to gain additional shares in the market as well. So far in 2008, we have won significant new business with such customers as Albertsons’s, Harris Teeter, Publix and Tesco Fresh And Easy.

Let me now turn to our cost reduction and operational efficiency initiatives. They are all on track. Salary headcount is down 6% from year ago. Corporate expenses are down more than 40% year to date. Overall, SG&A adjusted for FX is down 5% year to date. In the September quarter, we began producing for sale out of our Mexico facility. The ramp up has gone exceedingly well and we are on schedule.

We have now completed the transfer of two refrigeration manufacturing lines from our Australian facility to our China facility and our plans are proceeding on schedule there. Regarding our move of refrigeration product lines from Danville to Tipton, we approximately halfway through the move and are on cost and schedule.

Among our new rationalization initiatives, we are in the process of closing refrigeration manufacturing facility near Madrid by the end of 2008 and will service the Spanish market from our one remaining facility near Barcelona. In commercial HVAC, we are in a process of optimizing our Northern European structure to reduce costs and increase the focus on our customers. Back office operations are being centralized into one location in the Netherlands while sales and service operations remain close to the customer in each of the respective countries. Total annualized savings from these two new activities is expected to be more than $4 million starting at 2009. Our strategic initiatives to rationalize our operations and manufacturing footprint around the world continues, where possible we are pulling in future activities.

Cash generation in the quarter was strong. Cash from operations was 160 million, consistent with the year ago. Free cash flow for the first nine months in the year was $102 million, up $36 million compared to the same period a year ago. Our balance sheet remains strong. Cash and short term investments were $141 million at the end of September. Net debt was $261 million, an $80 million improvement from June. Our debt to EBITDA ratio is 1.2. In today's environment, we like our strong balance sheet and the continued cash generation power of our business.

Before I turn it over to Sue, I would like to wrap it up with our thoughts on the remainder of the year. It has been unprecedented times globally. There has been a great deal of uncertainty in the markets. Lennox has executed well within market softening further on a global basis. We are reducing our revenue in EPS guidance for 2008. We are revising our full year revenue growth assumptions from flat to down 2% to a range of down 3 to 5%. We are revising our 2008 full year adjusted earnings per share guidance from $2.85 to $3 to a range of 265 to 275. GAAP EPS is now expected to be 229 to $2.39 versus previous guidance of $2.61 to $2.76. The changing GAAP guidance reflects the full year impacted restructuring charges announced in third quarter.

Lennox will continue to focus on operational excellence from these difficult market conditions. Leasing cost, enhancing our competitive position and executing on our strategic initiatives.

Now I will turn it over to Sue.

Susan Carter - Chief Financial Officer

Thank you, Todd. Good morning everyone. I will provide some additional commentary on the business segments for the quarter, starting with Residential Heating and Cooling.

Revenue from our Residential Heating and Cooling business decreased 9% to $414 million. While our volume was down 16%, price was up 4% and mix improved 3%. The volume declined compared to a year ago was driven by a significant drop in new construction as well as softer replacement business due in part to cooling whether in August and September. Overall for the third quarter cooling degree days were down 11% from last year.

Segment profit was $55 million, down $9 million with a margin of 13.4%. This compares to segment profit of $64 million and a margin of 14.0% in the third quarter a year ago. The business continues to improve factory efficiencies and aggressively reduce its cost structure.

Turning to our Commercial Heating and Cooling business; revenue for the commercial business was $251 million, down 1%. Excluding favorable foreign currency revenue would have declined 4%. We realized favorable pricing of 4%, volume was down almost 1% and mix was down 7% on a difficult comparison to the prior year quarter. Segment profit was up 7% to a record $40 million. Segment profit margin was 16.0% versus 14.8% a year ago.

Our European business realized very strong sales and profit growth driven primarily by demand in Eastern Europe. Improved pricing and reduced cost benefited the results.

In North America volume was down primarily due to continuing new construction push outs into 2009 of national retail accounts. Mix was down as there was a difficult comparison to the third quarter of 2007 when our Strategos systems first began shipping in volume to a major national account.

As Todd mentioned, we continued to be successful signing up new national accounts with 52 new customers in 2007 and 2008 so far. Outside of our national accounts business, we achieved good revenue growth over the prior year quarter.

Moving to our Service Experts business; sales in the third quarter were $168 million, down 9% with and without the impact of foreign exchange. Segment profit was $5 million or a margin of 2.7% versus $9 million or a margin of 5.0% in the year ago quarter. Volume was down 9% on significantly lower residential business. Further cost reductions and operational efficiency initiatives are ongoing including centralized cost centers and handheld protect machines as well as reduced headcount.

In our Refrigeration segment, third quarter sales grew 3% to $163 million. Sales were down 1% when adjusted for favorable foreign currency. Volume was down 4%, mix was flat and price improved 3%. Sales were up in North America and Asia and down in other international markets. Segment profit for the quarter was $17 million down six percent from a year ago. Segment profit margin was 10.3% in the quarter compared to 11.3% a year ago. As Todd mentioned manufacturing rationalization is currently underway with the moves from Australia to China and consolidation in Europe. Restructuring charges in the third quarter were $6.2 million aftertax, and included projects across all business segments. Restructuring charges impacted our GAAP earnings by $0.11.

Corporate expenses improved 30% from the year ago quarter, driven primarily by lower compensation expense and overall tight budgetary controls. For 2008, we now expect corporate expenses to be approximately $60 million at the low end of our prior range of 60 to $65 million.

Overall SG&A when adjusted for $3 million of unfavorable foreign currency was down 8% over the prior year quarter. Cash provided from operations for the first nine months of 2008 was $139 million, up from $110 million in the same period a year ago. This improvement is primarily due to a reduction in working capital level and the timing of tax payments.

Free cash flow was $102 million for the first nine months of 2008 versus 66 million for the same period a year ago. Capital spending was $37 million year to date, including 16 million in the third quarter. Cash provided by operations in the third quarter was $160 million, consistent with $160 million from the third quarter a year ago.

Our working capital as a percent of trailing 12 months sales for the company was 18.1%, the same percentage as year ago. However, our quarter-end working capital ratio at 17.9% improved 170 basis points from the third quarter of 2007.

Let's talk about liquidity. In addition to the company’s strong cash generation, Lennox has a strong balance sheet. Cash and short term investments were $141 million at the end of September. The current ratio exceeded 1.5 times. Debt to EBITDA was 1.2 times at the end of September. We have $650 million revolving credit facility in place through the year of 2012. In addition, we have $37 million of subsidiary credit facilities and $125 million asset securization line. In summary, Lennox is well positioned and we have not seen any financing effects on the corporation at this time from the global credit crises.

Before I turn it over to Q&A, I'll briefly talk about our outlook for the remainder of 2008.

On the residential side, we continue to face a very difficult market environment. NAHB currently estimates North America total housing starts to be down 30% for 2008. Our best estimate for the replacement market is down mid single digits. Assuming the residential market is 70% replacement and 30% residential new constructions, you go to a decline of low double digits for the total residential market.

Turning to commercial side, our retail national account business has softened further and we are seeing more push outs. Our non retail business has been solid but we remain cautious for the balance of the year. Overall we see the North America commercial unitary market down in the high single digits for 2008.

In refrigeration, we have seen a slowdown in our European business, most notably in Spain and UK and to a lesser extent in France and Germany. As Todd mentioned earlier, given these latest assumptions, we are revising our full year revenue guidance from the range of flat to down 2% to a range of down 3 to 5%.

We are also revising our 2008 adjusted earnings per share guidance. We now expect a range of $2.65 to $2.75 versus our prior guidance of $2.85 to $3. This change include the diluted share count assumption for the year of about 59 million shares. We expect a 37% tax rate for the year. Our new GAAP earnings per share range of $2.29 to $2.39 reflect the full year impact of additional restructuring charges announced in the third quarter. Regarding capital spending, we are lowering our guidance from 2008 to approximately $70 million versus our prior guidance of $75 million.

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

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]. And our first question is from the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Jeff Hammond

Hi good morning.

Todd Bluedorn

Hi, Jeff.

Jeff Hammond

I just wanted to understand I guess the provision, it seems pretty heavy at least in my model, pretty heavily weighted to the fourth quarter. So I am just wondering if anything has changed dramatically you know, from a trend standpoint within any businesses that get you to a much more difficult 4Q or perhaps, you guys had higher expectations for 3Q then maybe the Street?

Todd Bluedorn

I think the way I think about it Jeff is, we said something similar last year I tend to view the second half of the year, third and fourth quarter together given the seasonality of the business. And so, I would look at how we adjusted to second half of the year, unless about what the drop was in fourth quarter.

Jeff Hammond

I mean the third quarter come in below your expectations?

Todd Bluedorn

I am not going to answer that directly. I will answer it maybe briefly, which is to make the point is, we gave revenue guidance of then the second quarter, we said zero to minus two, given that we were down first half of the year, I believe 4% that sort of implied flattish during the second half of the year and our revenues were down 5% at third quarter. We talked about cool whether in third and fourth quarter with cooling days being down 11% from prior year. So I think its pretty clear that the market was little softer in third quarter than what our guidance would have led you to believe, we thought.

Jeff Hammond

Okay. And then you know, commercial I guess, you continue to talk about push outs and things getting more challenging, but the volumes this quarter were pretty resilient, just trying to understand that a little bit better, any kind of pull forward? And then also within the -- can you explain, how you got the -- I mean was it really all Europe improvement, how you get the margin expansion despite pretty big mixed win?

Todd Bluedorn

We had a very strong quarter in Europe, both on the top line and on the bottom line. And so there is really a couple of forces that work on a commercial -- at least on a revenue line, which is a strong third quarter in Europe. Our non-retail and non-national account business continues to be up year-over-year and we continue to see push outs of some of our major national accounts. And I guess the force through that is, we continue to win in the market place to gain new national accounts. So third quarter revenue line and volume line was solid, but as we look in the fourth quarter and beyond we continue to see some of these push outs and reflected that in our guidance.

Jeff Hammond

And the mix would have a negative contribution on the overall margin?

Todd Bluedorn

Correct.

Jeff Hammond

Made up by the Europe?

Todd Bluedorn

Say the last question again.

Jeff Hammond

I guess to kind of the margin expansion question, it was at all Europe more than made up for the negative mix?

Todd Bluedorn

Europe and pricing more than made up for the negative mix.

Jeff Hammond

Okay. And then just I guess, we continue to hear I guess more negative things about Europe, some surprised and to strengthen that business, anything unique or one time in nature or is that a function of starting to get that business in order, I guess just why the conflict versus what we will be sharing from a macro level?

Todd Bluedorn

I think I would answer it maybe with two points, one is, we continue to get our operations in Europe in order, the restructuring that we announced this quarter will put additional cost reduction tier one in our bags as we go into '09. Point two would be, we talked about on refrigeration business we are seeing a same dynamics in Europe that others are seeing, which is a slowdown in refrigeration and we talked about that. Third on our commercial HVAC business, we don’t have the European footprint at some of our international competitors do and so on any given quarter, given some customer drivers specific customer drivers unique to us, we can have good quarters, we can have bad quarters on the revenue side. So I'm not sure I would read that our strong third quarter is counter to what you're hearing more broadly in Europe. I think the diagnosis of Europe of slowing down and what we said about refrigeration is how we see end use demand in Europe.

Jeff Hammond

Okay. And then just one final question moving over to commodities, can you just -- I mean it looked like your gross margins continue to expand despite a challenging demand environment. It looks like the price cost dynamic is at least near term, somewhat favorable, and just with copper falling off a Cliff, down around two buck, and steel I guess coming well off its peak, how should we start thinking about price cost gap moving into 2009?

Todd Bluedorn

I think the way you should think about price/cost is the way we have talked about it, which is we look to get price at a minimum to offset commodity shocks to the business. When you talk a little bit about commodities, a lot of this I know you know but with other folks on the line, to be clear, we're all on the same page, which is we hedge copper and have fixed forwards on aluminum to mitigate the volatility. So an implication of that is when prices are going up, you protect yourself on the volatility, and when prices go down, you shed yourself from the volatility. For 2008 overall, we are 78% hedged on copper, and have fixed forwards on 69% of our aluminum. Steel, as we've talked about earlier, we had significant increases mid year, as our suppliers re-wrote with surcharges added our long-term agreements. And while spot pricing has moved recently, the pricing that we're paying to the mills and the surcharges that were put on top of us, that hasn't changed overall commodity costs are significantly higher in 2008 versus the prior year. And as I have said we have driven market pricing to offset that. Now, as we think of going into 2009, we also expect commodity costs, even with some of the movements you've seen on some of the index, given our hedging positions, given our steel pricing, and given the year over year costs, we expect commodity costs to be higher in 2009 and expect to drive price in the marketplace to cover that.

Jeff Hammond

Okay. Are you starting to get, hear of, or get any relief on these surcharges on a near-term basis on steel or when would you expect that to happen?

Todd Bluedorn

No, and we're working hard to make it as soon as possible.

Jeff Hammond

Okay. And then on copper, I guess with copper coming down to two bucks, just taking into account your hedges, when would you at least start to feel some partial benefit from lower copper?

Todd Bluedorn

Not in 2008. When we are in December, we will paint a more precise picture about 2009.

Jeff Hammond

Okay. Thanks.

Todd Bluedorn

Okay, thanks.

Operator

And our next question from the line of Curt Woodworth with JP Morgan. Please go ahead.

Curt Woodworth

Hi, good morning.

Todd Bluedorn

Hi Curt. How are you?

Curt Woodworth

You talked about the incremental cost savings of $4 million, in the commercial segment. With all the other restructuring that you've done this year, what is your expectation for total operational cost takeout for the business in 2009?

Susan Carter

Curt, it’s Sue. Let me try this one. What we've talked about for 2009, when you add in the new projects is that we would be north of $30 million in savings. Some of that coming from the Bellevue foundry that we closed a couple of years ago, the prior projects, and then adding on the new projects adds about $4 million as we said in the script.

Curt Woodworth

So 30 million of total cost savings or would that be more than annualized number you would get to by year-end?

Susan Carter

I think we would say that they would probably be one and the same for 2009. They would be roughly close.

Todd Bluedorn

And so let's rattle off the restructuring to make sure we all have the same list, which is the Bellevue closure, which was embarked upon, and we've seen much of that benefit this year. Our Lynnwood closure, our Danville closure, our New Zealand closure, and then our most recent announcements in Spain and European restructuring.

Curt Woodworth

Let me ask it another way, because you have achieved some, you have realized some of these benefits already this year. So what would be the incremental cost savings to the company next year? Because I would think that 30 million would be inclusive of some of the benefit this year.

Todd Bluedorn

Order of magnitude, we have talked about the Bellevue closure having 10 million of savings. Order of magnitude, you could take that out, and so we have about a $20 million year-over-year annualized savings.

Susan Carter

That's fair, yes.

Curt Woodworth

Okay. And then so I add four to that, or would that be inclusive of…?

Todd Bluedorn

The four is in the 20.

Curt Woodworth

Okay, great. And then in terms of your share buyback program, can you comment on how you are looking at that now relative to old stock prices, how many shares did you buyback this quarter and what is left on your authorization?

Todd Bluedorn

We didn’t purchase any shares this quarter, although on a year-to-date basis on a prior authorization we have bought $297 million of shares this year. When we announced $300 million stock repurchase plan, we talked about it as being a more opportunistic plan than the 500 million where we had a clear sunset on when it was going to be complete. We're balancing, buying the share buyback versus the financial parameters, what's going on in the marketplace, and business opportunities. Our cash flow deployment strategy that we've talked about often is use words like balance and discipline and look to give money back to our owners while at the same time driving growth organically and through acquisitions where they make sense, and dividends and share repurchase are a way to do that. So that is a long-winded answer. We're going to opportunistically look to buy back shares.

Curt Woodworth

Yeah, okay. And then in terms of your compressor and motor sourcing initiatives for next year, how much of those input costs have you already locked in for the year?

Todd Bluedorn

We're still in negotiations with our supply base for 2009. And when we're together in December, we will give a little bit more visibility and color to the focus and progress that we've made. I have talked about, we have talked about, over the last 18 months, the opportunities that are in front of us to be more international in our supply base strategy. We've built the teams, have made significant progress on that and when we're together we will talk more about it. But the short answer is we're not locked in on our component pricing yet.

Curt Woodworth

Okay. And then on commercial, sort of getting back to Jeff's question, I mean if you look at this quarter the $1.10, you're up something like 20%, EPS growth, 18%, EPS growth year on year, at the low end of your guidance for the fourth quarter, means you would be down roughly 22% year on year. So the potential trend line run rate entering ’09 does seem like there has been seem somewhat of a step function change in potentially the outlook, given the guidance reduction. So can you just maybe walk us through -- it seems like commercial and refrigeration are the most difficult segments to forecast. Just thinking about ’09 if the new construction market is going to be doing 15, 20% maybe that’s too pessimistic. What is your strategy to either take further costs out, go after the replacement market, new product development, how do you think the business would hold up?

Todd Bluedorn

I understand the question and you can imagine in the summer I'm going to go through that chapter and verse both about what we think is happening in end markets and what we can do to offset it. Let me get it to maybe earlier in your question first which is I would advise not to read a step function change in the trajectory of the line. I would tend to view it as looking at the first half of the year and the second half of the year, that there is chunkiness in our business that I think can skew quarters. I think we saw a similar dynamic last year in the third and fourth quarter as we're seeing this year. So I would tend to view it as look at the line first half, look at the line second half. And I think the lines are pretty similar in terms of both revenue and loss performance first half of the year, the second half of the year. In terms of what we are going to do, I think the play book is pretty clear what we are going to do which is what we have done, which is aggressive movements on our factory restructuring, have said continue to use words in all of my comments of more to come, and that means just that, we're internally working on things we haven't publicly talking about, so more to come that we will continue to focus on discretionary spending and on SG&A. Although we start to get to the point of it's more challenging a third year, into a market downturn but we continue to hammer on that and obviously the long-term play there as the markets return that we keep it down. I just hinted earlier that we're doing things on the supply chain that we haven't done before, and I think there is -- in fact, I know there's opportunities there as we roll into '09, in a way that we haven't seen before in this business. And so we will talk more about that. So I think we continue to attack on the cost leverage. At the same time, transformational initiatives, whether it’s on our products, whether it’s on our distribution channel, we continue to make those, also.

Curt Woodworth

Okay, great. And then just one last question, in terms of pricing, are you seeing any changes in price competition, do you feel like typically in market weakness, the value brand, the fighting brands can get competitive on price, are you seeing that? And just in general what’s your view of inventory levels for the residential side in the business?

Todd Bluedorn

Yeah. On the pricing side, the price across our businesses, the pricing that we have announced has stuck, and we think it has stuck with our competitors also. I think your point about at the low end of the market, you are starting to see nibbling around price, and some more aggressive pricing on the low end of the market. And we resisted that and so where we have been winning has been, and we talked about that on the residential side, we think we're doing very, very well on the premium end of the business and that continues to grow even in these difficult environments and we do what we need to do on the low end, but we resisted not protecting our price. In terms of inventory, what we see, and again, we see it a little different than our competitors, given that the majority of our residential business is one step, so (inaudible) with us. But what we see is conservatism and so the inventory levels we think are seasonably low as people wait to see what’s going to happen in the market.

Curt Woodworth

Great. Thank very much.

Todd Bluedorn

Thanks.

Operator

[Operator Instructions]. We go next to the line of Keith Hughes with Suntrust. Please go ahead.

Keith Hughes

Thank you. I had a question on corporate expense. You gave us some guidance of 60 million for the year. That's been very choppy and the numbers have been kinds of all over the place in 2008. My question is, one, why is that then? And number two, in 2009, will we see a more consistent spend?

Susan Carter

Well, Keith, this is Sue. Let me give that one a shot. You're right, from quarter to quarter, there is some chunkiness in the corporate numbers. But I think it’s fairly easy to explain. In the first nine months, we eliminated nearly all of our discretionary spending, we adjusted our compensation program, we adjusted our forfeitures for long term compensation program, and then in the second quarter we had a one time favorable foreign exchange impact on inter-company loans that was 4 to $5 million. So you see some things happening there for the full year and obviously going forward we will continue to closely monitor our corporate spending, and we think approximately 60 million is the right number for 2008.

Keith Hughes

And if I take that as a percentage of whatever your sales are, would I see a similar spend in 2009?

Susan Carter

Yeah, I think as you look forward, I think there is a couple of things. You know, one, as I said, we will continue to tightly manage corporate expenses on an absolutely basis and as a percentage of sales. We obviously expect to leverage the hard work that was done in 2008 as the markets recover. But with all of that, I would also say that as the markets come back, we will expect to see some increases, for instance, in our variable compensation programs that we took out this year but again, I think the cost reductions that we've done and the work that we've done with the budgetary constraints is going to continue.

Keith Hughes

Okay. Second question, could you just remind us again, how much cost -- how much raw materials are as a percentage of cost of goods sold, and then break them down, the biggest to smallest, among the materials?

Susan Carter

Out of the direct material buy, the commodity, so steel, copper and aluminum are about 35% of the direct buy; copper and steel are about equal size with aluminum being the smallest.

Keith Hughes

Okay. And what is that as a percentage of cost of goods sold? 35, is that right?

Susan Carter

That’s 35% of the direct material buy.

Todd Bluedorn

And direct materials about 80% of COGS.

Keith Hughes

Okay, I got it. Thank you very much.

Susan Carter

Thanks.

Operator

We have question from the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Jeff Hammond

Hi, guys. Just a follow-up here on Service Experts. It just seems like, you know, we've had a number -- you know, a healthy eight quarters of really rough demand on the residential heating and cooling business. And really, it is seemingly until this quarter, Service Expert had kind of been bucking that trend and holding up a little bit better, and it seemed to have capitulated, and I just want to understand if you've seen any major change in customer behavior, or what was driving that, or any particular nuances in the third quarter with respect to Service Experts?

Todd Bluedorn

No. I understand the question. As we talked in the numbers; the revenue was down 8%, which I think is a bit more than what we saw earlier in the year. I think they were affected by the weather and by the shift from replacement to repair that we've seen. And Scott, at the same time that he continues to execute on the transformational initiatives, whether it’s the centralized call centers or the hand-held devices and the centralized operating systems, in the near term, is aggressively right-sizing the business for the market softness that he saw in the third quarter. So we are aggressively taking heads out of the business.

Jeff Hammond

But imagine if you get repair versus replacement that that business hangs in a little bit better than say the equipment side?

Todd Bluedorn

I think the difference is we being service experts, make more money on a replace than we do on a repair.

Jeff Hammond

Okay. And are you still able to -- have you still been putting through fuel surcharges? Is that effort still working?

Todd Bluedorn

Well, as you know, fuel is sort of bouncing around and had a good bounce here the last 45 days or so. We continue to market by market, either put it in our standard hours that we charge out to the customer, use surcharge, so we use different vehicles to do it, but we've been aggressive on passing on our additional costs whether it is on equipment side or whether on the fuel side to the end customer.

Jeff Hammond

Okay. And then finally, are you seeing any major change in trends on service contracts, either fewer people signing up, or fewer people renewing?

Todd Bluedorn

Not that I am aware of, no.

Jeff Hammond

Okay. Thanks a lot.

Todd Bluedorn

Thanks.

Operator

Our next question is from the line of Michael Coleman with Sterne, Agee. Please go ahead.

Michael Coleman

Good morning.

Todd Bluedorn

Hey Mike.

Michael Coleman

The startup of your facility in Mexico, in the quarter, were you running redundant lines? Was there additional costs on the startup that you won't incur in next year's third quarter?

Todd Bluedorn

I don't know, if I would think about it that way. I don't have the numbers on my fingertips, but the way we have moved a line, and these were lines that we moved out of Marshalltown, is we build inventory, shut down the lines, a big pieces of the equipment, or some of the equipment that we use, equipment that we moved out of Marshalltown down to Mexico, plus adding new line equipment, and then we ramped up in Mexico, and then picked up the production for our merit product line. So I guess, I wouldn't necessarily view -- I might view it as lower inventory once we're all done with this. And as we take fixed costs out of our Marshalltown facility to offset the volume that we've taken out, we will see some fixed costs go away. But all of that is baked into the guidance that we've given in terms of the savings that we're going to see on our Mexico facility.

Michael Coleman

The second question, on Mexico, is if the -- I think the capacity of that facility is significantly higher than what Marshalltown and maybe you can correct me on that, but do you have -- you run the risk of under absorption in that facility is a residential markets, you know, take longer to recover?

Todd Bluedorn

On the first question, I don't think we've ever talked about that in terms of the capacity of the facility versus Marshalltown. As you well know, it is quite literally, it is about how many lines you put in, and the Fab capacity that you have, but I don't think we've talked about the size. The answer to your question is we continue to look at what we need to do to take fixed costs out of our manufacturing base, both in residential in the US and around the globe. And so we're cognizant of what is happening with the markets and what we have to do to take fixed costs out.

Michael Coleman

Thanks.

Todd Bluedorn

Thank you, Michael.

Operator

Our next question is from the line of Curt Woodworth with JP Morgan. Please go ahead.

Curt Woodworth

Yes, hi, just a quick follow-up on the commercial segment. Given the commercial and construction market definitely deteriorated pretty rapidly, can you just update us on what percent of the volume is after market, what percent of the volume in your commercial segment is new construction? And then within the new construction segment, can you go through kind of the key verticals, I know retail, I think, is the main one. But I'm not sure what the weighting is. And then lastly on the new national account, the 23 wins, can you give us some sense of the size of that sales opportunity? You know, roughly what that would mean to you in terms of incremental sales in 2009?

Todd Bluedorn

Let me sort of march through some numbers for you. When you look at our US commercial HVAC business, 60% to 65%, more like 60% this year, is new construction, 40% is replacement, and you know that inverse from what the industry is. We've made lots of focus on growing our replacement business. And have good results this year. When you think about the other cut that we talk about, the business, is about half of our business is a vertical being retail. And a majority of that is new construction but we also have replacement with some of our retail customers. Other major verticals that we have are healthcare, small to medium-sized offices, schools, are other important verticals. And so when you think about those verticals you think about segments that are less impacted by things at least in the near term, things that have happened here over the last year or so, and that's why when we talk about our commercial business in North America, we talk about the national accounts or the retail segment being down, but the other part of the business, the non-retail segment of our business actually being up year to year.

Curt Woodworth

And where is the replacement market been up year to date?

Todd Bluedorn

I don’t have that number on my finger tips, Curt.

Curt Woodworth

And Europe is about 25% of the segment.

Todd Bluedorn

30%.

Curt Woodworth

30% today. Thank you.

Todd Bluedorn

Thank you.

Operator

And I will now turn it back to Todd Bluedorn.

Todd Bluedorn

Great. Thanks, everyone. Lennox had strong operational execution in the third quarter that offset market head winds and led to strong cash generation and solid earnings, including record earnings per share. However, with global market conditions continuing to soften, we are reducing our sales and profit guidance for the remainder of the year. Our previously-announced cost reductions and operational efficiency initiatives are on track, and we are accelerating additional programs. All of us at Lennox remain focused on execution and operational excellence. Thank you all for joining us this morning. Thanks.

Operator

And ladies and gentlemen, that does conclude our conference call for today. We thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.

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Source: Lennox International, Inc. F3Q08 (Qtr End 09/30/08) Earnings Call Transcript
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