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Ingersoll-Rand Co. Ltd. (NYSE:IR)

Q2 2010 Earnings Call

July 23, 2010 10:00 am ET

Executives

Bruce Fisher - VP, IR

Mike Lamach - Chairman, President and CEO

Steve Shawley - SVP and CFO

Analysts

Robert Wertheimer - Morgan Stanley

Jeffrey Sprague - Vertical Research Partners

David Raso - ISI

Longbow Securities Eli Lustgarten - Longbow Securities

Nigel Coe - Deutsche Bank Securities

Alex Blanton - Ingalls & Snyder

Bob Cornell - Barclays Capital

Jeffrey Hammond - KeyBanc Capital Markets

Steve Tusa - JPMorgan

Operator

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

Bruce Fisher

Thanks, Tom. Good morning everyone and as Tom said welcome to Ingersoll-Rand second quarter 2010 conference call. As you know, we released earnings at 7 A.M. this morning and we'll broadcasting in addition to this phone call through our website at ingersollrand.com where you'll also find the slide presentation that we'll be using this morning.

These materials from the call will be archived on our website and will be available tomorrow morning at 10:00 A.M.

Now if you would please go to Slide 2 in the slide presentation. And I'd just like to remind you that statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor Provision with Federal Securities Laws.

Actual results may differ. Please see our SEC filings for a description of some of the factors that may cause actual results to vary materially from anticipated results. In addition, if you would please refer to Slide number 21, which covers the use of non-GAAP measures to describe the company performance.

Now I would like to introduce the participants on this morning's call. We have Mike Lamach our Chairman, President and CEO. Steve Shawley our Senior Vice President, CFO. Janet Pfeffer our Vice President, Business Development and Investor Relations. Who is taking over my role and Joe Fimbianti our Director of IR.

Before I turn it over to Mike and Steve, I'd like thank Joe for his support through the years. I'd also like to wish Janet all the best for her new role. I know our analysts and investors will enjoy working with her.

Also I would like to thank Mike, Steve and other leaders and people I've worked with over the years of Ingersoll-Rand, Trane and ASV. It's been a privilege to know all of you. And I'd like to thank the folks from the investment community, it's been a pleasure working with you sharing the ups and downs of the markets and together gaining a better understanding of our businesses. Thank for your energy, your intellect and your curiosity. You made my job much more interesting, rewarding and fun. And so with that, if you would please go to slide number three and I'll turn over to Mike.

Mike Lamach

Thanks Bruce. So we're talking last night. It was 41 quarters, I think we've had the pleasure of working with you for nine of those. So, yeah, we want to tell you thank you and wish you all the best for you.

So good morning to people on the call. Thank you for joining us today. In the second quarter, we continued our focus on driving top Tier operational performance. We delivered strong revenue growth with three or four sector achieving top line increases. We significantly improved our productivity for the sixth straight quarter and we expanded our margins, grew our earnings and generated strong free cash flow.

Second quarter earnings from continuing operations were $0.76 per share including $0.04 of restructuring and productivity investments. EPS exceeded the top end of our project second quarter earnings guidance range of $0.62 to $0.72. For the quarter, revenues were $3.7 billion, up 7% versus prior year and above the top end of our guidance range of 3 to 6%.

During the quarter, we continued to see strong bookings of a number of our early cycle businesses are showing good growth and the company overall, orders were up 10% and improved in each of our segments except for commercial security which continues to be hampered by the ongoing decline in North American commercial construction activity.

Our backlog also increased significantly, up 15%. Operating margins for the quarter was 10.3% driven by productivity and higher volumes. All of segments improved operating year-over-year and total segment margins were up 2.8 percentage points for the second consecutive quarter.

We also had a 49% leverage on our year-over-year revenue gains. We achieved a 4.4% increase in gross productivity as we continue to drive disciplined cost controls and operational improvements. This performance includes approximately $26 million of unplanned supply chain cost incurred primarily to expedite delivery of some key components to meet strong customer demand these additional cost caused an 80 basis point drag in our year-over-year productivity.

We also held or gained share in most of our business and our innovation agenda continues to gain traction as we increase investment in the development and introduction of critical new products and services we expect that these actions will help to mitigate some of the near term market choppiness and fuel our growth as the recovery fully kicks in.

We also remained focused on cash flow management, in retaining the benefits achieved through the operational attention we paid working capital improvements over the course of past 18 months. We built up cash in the quarter and are in a great shape to repay a $250 million of maturing debt in August and we are on track to deliver $1 billion of available cash flow for 2010.

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

Please go to slide five. Next slide provides a look at the trends in our revenue by segment we think revenue excluding currency shown on the bottom of the chart gives the better view of our organic sales performance and our comments will focus on this measure as you can see on the bottom chart, second quarter represents the first up-tick in revenues we've seen in a long time, in fact we last had quarterly revenue growth in the second quarter of 2008. We had improvements in all of our sectors expect for Security, which was flat overall despite a decline in domestic commercial construction market.

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

Please go to slide six. This bridge analyzes the change in second quarter segment operating margin, year-over-year. Second quarter operating margins were 10.3%, an increase of 2.8 percentage points compared with 2009. As you can see, volume, price and mix, and $250 million of additional revenue added 1.6 points to our operating margins.

Productivity was the biggest driver and netted against inflation, also increased margins by 1.6 percentage points. We continue to invest new products, and those activities coupled restructuring investments, reduced margins by 14 basis points. Our focus on productivity, which will reduce our fixed and variable cost structure in our innovation agenda remain core elements of our strategy, as we position ourselves for higher margins and faster than average growth as our markets recover.

Please now go to slide seven. This slide explains how we exceeded the EPS guidance range that we provided in April. At that time, we indicated that we expect to be in the range of $0.62 to $0.72 per share from continuing operations with the midpoint value of approximately $0.67. Compared with prior expectations, price was flat for the quarter, which caused $0.02 of the EPS drag.

Higher volumes contributed an additional $0.06 per share. Productivity was better than expected, but it was negatively impacted by $0.06 of higher supply-chain cost, resulting in a $0.04 shortfall to our April expectation. Inflation, interest, and investment timing also contributed to better earnings.

Finally we reclassed our European refrigerated display case business which we are in the process of divesting to discontinued operations, and that increase continuing earnings by about $0.02.

Steve will now take you through a review of our reporting segments.

Steve Shawley

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

I'll talk first about the Trane Commercial HVAC business and provide a quick look at the markets. Globally, non-residentially HVAC equipment markets declined mid-single digits in the second quarter, following a decline in the mid-teens in the first quarter. Both, the Americas, and Europe, Middle East showed mid-single digit declines while Asia continues to demonstrate good growth.

Based on what we see today, we believe the Americas market as bottomed, and based on market activity, we maybe approaching an inflection point. We also expect Europe Middle East markets to continue to decline at a slower pace and growth in Asia to remain in the mid-teens.

Global commercial HVAC second quarter revenues of $1.3 billion were up 2% versus prior year on a reported basis and up 1% excluding the effects of foreign exchange.

Total global commercial equipment revenues were inline with global markets, down 5% excluding FX. Americas' equipment sales were down close to 10%. Europe and Middle East were mid-teens and Asia was up high-teens, all excluding FX.

Global parts, services and solutions revenues increased by 11% excluding FX. This is the strongest year-over-year increase we've seen since the fourth quarter of 2008 reflects to both improving demand and our ability to sell directly to building owners.

Shifting to orders, global commercial HVAC orders were up 9%, and up 7% excluding foreign exchange. This is the second quarter in a row that total order growth was positive, following a string of five quarters of negative growth. The second quarter was driven by equipment orders, which were up 7% and contracting and service orders, which were up 13%.

Our backlog continues to grow. We ended the quarter with a global backlog of equipment contracts, services and parts of over 1.4 billion. Global backlog was up 16% on a reported basis. Equipment backlog increased mid teens while contracting backlog increased by over 20%.

Geographically, backlog in the Americas was up mid-teens and international backlog was up almost 20%. Asia continuous to be strong and Europe and the Middle East were down slightly on a reported basis but up mid-single digits excluding FX.

In summary, although commercial equipment revenues have shown a downward trend year to date, our recent orders and market outlooks suggest that we are approaching the inflection point. Service and contracting are now showing solid growth so far in 2010 and our strong backwash should support revenue growth for rest of the year.

In addition, our productivity and restructuring actions are helping to improve margins and we continue to launch new products which will put us in good position for leverage improving markets when they materialize.

For the global Thermo King Transport business, revenues increased by 30%, which is consistent with significantly improving markets compared to last year. Our worldwide refrigerated truck and trailer revenues moving faster, up 39% compared with 2009, with strength in all key regions.

Global, bus HVAC shipments and marine container sales both increased substantially due to easy comps and improved end market activity. TriPac auxiliary power unit volumes increased significantly compared with last year based on new product introductions and relatively higher diesel fuel prices. Total Thermo King orders increased by 22% in the second quarter setting the stage for continuing improved sales and operating earnings for the balance of 2010.

Looking at stationary refrigeration, global revenues were down 1% excluding the Cox European business. Overall bookings increased by 4% in the quarter. North American display case revenues were up 5% primarily driven by supermarket upgrades and remodeling projects at several of our major customers.

We have pro actively reduced our participation in some low profit contracting projects resulting combination of better product mix and productivity helped to improve our North American margins by 3 full points in the quarter. Operating margins for climate solutions was 9.7% in the quarter compared with 7.7% last year. This 2 point margin improvement was driven by volume gains, productivity, and cost reductions and better mix.

Please go to slide number nine. Industrial technology second quarter revenues were $625 million up 16% on both a reported basis and excluding FX. Industrial markets are clearly recovering after stabilizing in the first quarter. Orders for air and productivity products were up 29%, the strong improvements in all geographies.

Club car revenues increased by 27% compared with last year as demand picked up in both the Gulf and utility vehicle market. Year-over-year golf car market share also improved. We have seen a significant increase in orders from golf car replacement demand and total bookings were up 19%. Industrial's operating margin of 12.6% was up 5.5 percentage points primarily from higher revenues, better product mix and productivity.

Please go to slide number 10, the residential solutions sector, which includes Trane and American standard HVAC product lines and the Schlage Security Residential Business and second quarter revenues of $641 million, up 10% compared with last year. Excluding foreign exchange, revenues were up 13%. It appears we have finally reached a turning point of the long down cycle in residential markets and we expect improvements going forward driven by strengthening of the replacement market for residential HVAC and slow improvement in the residential construction.

Total reported revenues for the residential security portion of the sector were down about 8%. North American revenues were up about 7% primarily due to an improving remodel market and the bottoming in the US new builder channel. This improvement was offset by South America's results, which included significant negative currency translation related to the devaluation of the Venezuelan Bolivar.

The HVAC business we estimate the industry shipments and motor bearing units increased by about 9% over prior year. Our residential HVAC sales were up 14% principally from improvements in replacement sales, channel restocking, and the introduction of new products. Operating margins of 10% increased significantly compared with 2009 driven primarily by volume and productivity.

Please go to slide number 11. Revenues for security technologies were $421 million, down about 1% and flat excluding currency. America's revenues in the commercial sector were down 6% outperforming the 20% year-over-year decline in commercial construction markets.

Our European security business was down approximately 2% on a reported basis and up 4% excluding currency. Asia revenues were up over 40% of increasing sales in China. Operating margin for the quarter was a very strong 21%, up about 50 basis points despite negative mix effect from the North American sales decline. Strong productivity and somewhat lower investments drove the improvement in margins.

Please go to slide number 12. Let's switch gears to talk about productivity. As you know we have set a long-term goal of delivering 5% gross productivity every year. For 2010 our target of 5% total productivity translates into savings of approximately $650 million.

In the first quarter, we achieved $151 million in savings in line with our expectations. For the second quarter we achieved similar productivity of $149 million or 4.4%. We were very disappointed with the fact that we incurred an unexpected cost associated with inefficiencies in the supply chain and in some of our factories as we ramped up to meet the higher volumes.

This translates to about eight tenths of a point in loss productivity. These issues have largely been rectified and we don't expect any significant lingering after effects in the second half of the year. We are continuing to target our full year productivity savings of 5% with a divestiture of Koxka, our new savings target becomes $634 million.

In effect, divesting Koxka allows us to accelerate the earnings improvement we would have achieved over time as planned within our footprint rationalization program. By moving Koxka to discontinuing operations and restating history, this earnings gain will not show up as productivity. A decision to divest Koxka also avoids cash restructuring expenses that would have otherwise been incurred.

Please go to slide number 13. This chart updates our manufacturing, overhead and footprint improvement programs. As we said, this is a long-term program. So far this year we've announced nine manufacturing plant closures and four product line movements.

The Koxka divestiture also removes two additional manufacturing facilities, bringing the total to 11 fewer manufacturing sites globally. We spent about $15 million of our productivity investments in the quarter on these programs and are on track to achieve our savings target.

Please go to slide number 14. In addition to our productivity programs, we continue to sharpen our focus on developing and launching new products and services. We expect about 18% or $2.5 billion of our 2010 revenues to be from new products and services introduced in the last three years, with a number of new offerings in each of our businesses. This is up from approximately $1.8 billion or 14% of sales in 2009.

We are increasing our 2010 spending on innovation-related investments by the equivalent of $0.15 to $0.20 per share over 2009. The slide shows four of the new products that we launched in the second quarter. Just to highlight two of them; residential solutions new secure key feature, which is on all Schlage residential products, is shown on this slide.

It is a high security, pick-resistant lock cylinder which enables homebuilders and homeowners to change keys at any time using an easy two-step process that takes seconds to complete. Secure key technology enables 10 times more key combinations and other locks, making the secure key design 10 times more secure for the key duplication and other rekeyable systems on the market.

The Hammerhead Low Profile Impactool offers the power of an impact with the reach of a ratchet. It's going to change the way our customers work. The hammerhead fits into tight spaces and eliminates awkward extensions and swivel sockets, which improves customer productivity.

Reinvesting in our business is critical to our future growth, and we have a growing pipeline of product and service innovations, many of which are synergistic and combine capabilities across our businesses. Much of what's in the pipeline is unique to Ingersoll-Rand and will continue to strengthen our market positions.

Please go to slide 15. We continue to achieve our deleveraging goals during the second quarter. Total financing was reduced by $46 million in the quarter and $212 million year-to-date. Cash balances ended up at $822 million, as we continue to build cash in anticipation of paying a $250 million maturity in August.

We also successfully reinstituted a three-year, $1 billion credit facility in the quarter and now have $2 billion of available credit facilities. We reduced our total financing by roughly $2.2 billion since the completion of the Trane acquisition in June 2008.

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

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

With that, I'll turn it back to Mike for the forecast.

Mike Lamach

Thanks, Steve. Please go to slide 18. Our forecast for the balance of 2010 is based on mixed but improving markets. We continue to expect a slow recovery in the US and European economies, growth in Asia and mixed activity levels in our major vertical end markets.

We believe recent activities indicate that we are seeing stages of recovery in refrigeration, industrial, club car, residential HVAC and residential security, as well as in commercial HVAC parts, contracting and service. We expect to see a continuation of the challenging conditions in the US nonresidential construction market for the balance of the year, which will continue to impact both Trane and security commercial business.

We are certainly encouraged by our orders and backlog but economic turns can be choppy, so we believe the best approach is to be conservative in our market outlook and continue to relentlessly focus on achieving our productivity targets, offsetting material inflation through price realization and continued investment in our long-term growth through innovation.

Based on this mix but the improving view of the world, we are raising our revenue range for the full year 2010 to up 4% to 6% compared with 2009. We expect industrial and residential to show gains in the upper single-digit range. Climate Solutions revenues expected to be up low to mid single-digits with low single-digit declines in HVAC equipment and gains in both refrigeration and contracting products and service.

Security is expected to show a year-over-year decline due to its exposure to non-residential building, especially in North America. This results in a full year forecast of $13.7 billion to $13.9 billion, equal to a 4% to 6% full year growth for total Ingersoll-Rand. This compares to our previous revenue guidance of 3% to 5%.

Please go to slide 19. As a result of an improved revenue outlook, we are now projecting full year 2010 EPS from continuing operations including restructuring and excluding $0.12 of one-time healthcare costs to be $2.18 to $2.38 per share.

Additionally, our forecast was built on the following assumptions. Our full year forecast assumes modest price realization year-over-year, a tax rate of about 19%, $0.25 per share of restructuring and productivity investments, and EPS based on a $341 million share account.

Third quarter revenues are forecasted to be in the range of $3.65 billion to $3.75 billion which is up approximately 5% to 8% compared with the third quarter of 2009. EPS from continuing operations is expected to be in the range of $0.70 to $0.80, again, including $0.08 of restructuring and productivity investments.

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

Steve and I would now be happy to take your questions.

Question-and-Answer Session

Operator

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

Robert Wertheimer - Morgan Stanley

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

Mike Lamach

Rob, I'd tell you from the get-go it's been disappointing from what I thought it would be. It is not a subject of sort of major positive variances in any of the business reviews that we do. I think there is some effect to it, but actually do not see it as a major tailwind or driver for us.

Robert Wertheimer - Morgan Stanley

Interesting. And do you have a sense to how this took people awhile to plan and get involved or you're just not seeing it in the pipeline either?

Mike Lamach

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

Robert Wertheimer - Morgan Stanley

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

Mike Lamach

I think it's a business that when we look long-term, we think we have the ability to grow that business 8% to 10% annually. So I think there is some catch up. I think there is some particularly early in the year where 2009 budgets were constrained. I think there was early spending by customers to make sure they were going to be able to spend. And in the event there would be a W shape recovery and maybe have budgets cut.

So I think there is a little bit of that. But I expect long-term that we can grow that business 8 to 10%. It's an enormous business, very fragmented, with a lot of global opportunity for us as well.

Robert Wertheimer - Morgan Stanley

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

Mike Lamach

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

Operator

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

Jeffrey Sprague - Vertical Research Partners

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

Mike Lamach

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

Jeffrey Sprague - Vertical Research Partners

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

Michael Lamach

I would separate the two issues here. One is the reduction of 11 roof tops for us, nine that we've announced, and two that we will divest. You know is independent of that I can tell you that the actions that we took there did not relate any of the issues we had in the supply chain. The issues that we had, had in the supply chain and this is something that I want to convey on the call. I will start by saying we're really trying to give all of you guys excellent guidance and of course just if we think we're going to miss it or potentially overachieve it. We're also trying to give you a lot of transparency on these calls as to what's going well and have a more balanced view. And certainly when you beat like we did, we probably could have buried that. And operational performance, don't know if there were too many questions on that.

I think we see it as we had an entitlement for $0.04 and we missed it, and it came really down to what I would call the science of sales, inventory, operational planning, and how we material plan and work with the supplier. It was in the road side of the business primarily and I think we've got the issue addressed. In fact we brought in a leader working for Todd in the last couple of months who ran Dell IR program for them to head out this function. I think its still important going forward.

But independent, Jeff, the closures and the announcements are going well. We made a series of announcements last Friday because they were European in nature. We tried to put those together and it actually delayed a little bit from the second quarter to the third quarter so that we weren't announcing closures in Europe sort of one at a time and going through debt by 1,000 cuts there, which isn't good for our people or the market. So that was the reasons for the pushout there as well.

Jeffrey Sprague - Vertical Research Partners

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

Steve Shawley

No. It has always been the same. It's the same number.

Operator

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

David Raso - ISI

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

Steve Shawley

Dave, I think it's more the macro concern. Typically our order backlog is maybe three months. We only have several product lines that go out for maybe six, but it's very, very small percentage of our portfolio.

I think when you look at this and still to quote our Fed chairman the other day, uncertainty in the markets, even if you look at the sequential bookings and revenues within month-to-month in the quarter, that you see those moves happening.

David Raso - ISI

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

Mike Lamach

Dave, this is Mike. One thing I would tell you that we think we have actually hit the bottom on some of the inventory business in the US, but it's so early to call that as a definite bottom but I would tell you it tends to be fairly conservative.

It has been a little bit surprising that there has been some flattening here and sort of the order activity there would suggest that we may have reached that bottom. I just don't know if we really have and I think that's where the conservatism comes in.

David Raso - ISI

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

Mike Lamach

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

David Raso - ISI

All right so those are the swings. And then trying to think about the back-half loaded productivity costs, you had $0.19 for the $0.25 for the year in the back half. How should I think about, I assume you have those savings coming in more 2011 given the spending is back-half this year. We've got $634 million of total productivity for 2010. How should I think about the way its back-half loaded and then 2011 savings?

Steve Shawley

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

David Raso - ISI

But then looking to 2011, a lot of your activity, your spends, which obviously been a future restructuring benefit is back-half loaded in '10?

Mike Lamach

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

David Raso - ISI

And last quickie for 2011, for the business segments, then where are those productivity initiatives most significant the back half of this year, when we think about quarterly 2011?

Mike Lamach

David, I'm going to defer a little bit. Because I mean these are plans that we haven't announced internally and haven't fully vetted, so I'm going to defer that for a quarter, okay, and I understand your question.

Operator

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

Eli Lustgarten - Longbow Securities

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

Operator

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

Eli Lustgarten - Longbow Securities

Okay. I'm sorry. You didn't hear me before I guess?

Mike Lamach

Yeah, that's it. We heard about pricing, costs and you dropped off.

Eli Lustgarten - Longbow Securities

All right. I'm not sure what happened. Anyway, can you talk a little again pricing in the presentation was slightly negative. You expect pretty gain, can you talk about what's going on in pricing and going on a give some focus on where within the corporation you're having some issues?

Can you also talk about material prices being a little less favorable, but inflation was more favorable? I guess you're separating it too out. So can you give us a cost price snapshot of what's going on?

Steve Shawley

Yeah, first on the pricing side, a couple of quarters ago, remember we started introducing something called top line margin expansion with an initiative to raise pricing systematically, program office, external resources and internal resources to focus on that.

And felt like we would be seeing that late this year, some benefit late in the year in that regard, and so as you look into Q3 and Q4 there is a higher pricing expectation where the initial actions begin to come through in the marketplace.

Sequentially from quarter one to quarter two relative to price, we improved slightly Q2 to Q1. I mean, Q1 was really flat. It was a 10 basis points decline. Q3 we picked it up modestly, you know, and maybe 60 basis points price improvement happening there, but we're also factoring in that we're looking at the possibility of higher inflation in Q3 and Q4.

Eli Lustgarten - Longbow Securities

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

Steve Shawley

Eli, if you look at where we thought we were going to be in the second quarter, just kind of focus on that and kind of take it from the guidance in the second quarter by the pieces, what Mike just went through in pricing wound up our pricing wound up to be a little bit unfavorable. So where we thought we were going into the quarter.

That's offset by the fact that inflation was less than we expected simply because we didn't see the increase in certain commodities like steel and others that we had forecasted at that point.

So in fact, what happened was the favorable inflation we saw in the quarter relative to our guidance was slightly offset by price, so net between price and inflation we probably picked up a penny of improvement.

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

Eli Lustgarten - Longbow Securities

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

Steve Shawley

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

Eli Lustgarten - Longbow Securities

Okay. And one final question is there anything that would prevent the security business from maintaining those wonderful margins despite the softness in demand?

Steve Shawley

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

Operator

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

Nigel Coe - Deutsche Bank Securities

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

Mike Lamach

You are correct on the second quarter, Nigel. What we look at, what we have in the forecast for the third and fourth quarter is the pickup in inflation. It's primarily being driven by steel prices. If you look at steel prices in the marketplaces are coming up. Steel is not good because a lot of our sub component suppliers use steel and index us whenever the prices go up.

So what we have in the third and fourth quarter is an increase in price realization to offset some of that pressure on inflation. So we're continuing to match the two in a way that says that we're driving price with the commodity inflations that we're seeing, but there is no question in the way we put this together there is more inflation in the back half and less than first half.

Nigel Coe - Deutsche Bank Securities

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

Mike Lamach

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

Nigel Coe - Deutsche Bank Securities

Okay. If I answer that correctly, pricing is say very flat, Mike, into 3Q, so if we got steel price inflation, does that mean that gap widens in 3Q?

Mike Lamach

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

Nigel Coe - Deutsche Bank Securities

Okay, Great. And then switching…

Mike Lamach

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

Nigel Coe - Deutsche Bank Securities

Okay, great. And then on residential, can you maybe just talk about how July started off in terms of HVAC shipments relative to your 2Q performance and maybe describe what you have seen in terms of inventory levels within the channel?

Mike Lamach

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

Nigel Coe - Deutsche Bank Securities

And how does that change during the quarter, Mike?

Mike Lamach

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

Operator

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

Alex Blanton - Ingalls & Snyder

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

Mike Lamach

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

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

Operator

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

Bob Cornell - Barclays Capital

Yeah, a couple of questions. The intrigue with the comment about approaching an inflection point in the commercial HVAC business, could you just expand on what you're thinking there and talking about orders, shipments, what?

Mike Lamach

Yeah, it's both, right. So it's a trend you can see where unitary is beginning at the shallow bottom closer to single-digit declines. Early I would say June, June bookings, we're showing actually even a little bit of favorability at one point, slight to prior year. You just get the sense that that market really has bottomed now into small to mid single-digit declines, spot and too close to call.

You'd love to see one more quarter or a few more months really of booking activity there, but it just feels better in the activity we're seeing. I would also tell you the activity we see before a booking relates to the amount of proposals and the amount of activity we're doing with customers. And that just seems to be feeling better as well.

Bob Cornell - Barclays Capital

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

Mike Lamach

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

Bob Cornell - Barclays Capital

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

Steve Shawley

Yeah, they sure did, Bob. Quite frankly, we were also a little bit surprised because we saw some pickup in the Thermo King business in Europe, and it is one of the other wildcards here as what's happening in Europe, and some of our businesses we actually saw some up ticks in June.

Bob Cornell - Barclays Capital

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

Steve Shawley

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

Bob Cornell - Barclays Capital

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

Steve Shawley

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

Bob Cornell - Barclays Capital

Okay. So commercial equipment was up in margin?

Mike Lamach

Yeah it was up but was very small. I would say marginally up.

Bob Cornell - Barclays Capital

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

Mike Lamach

We focused a lot on pricing in regional markets. If you look at what was going on in China in the fourth quarter and the first quarter.

Steve Shawley

On the volume, didn't see much upside, but we fixed that and we have gone out and made sure that pricing discipline is in place with the quotations that we have out there, and quite frankly some of the leakage we saw in the first quarter was pretty well cleaned up in the second. Our challenge is going to be turning positive in the third.

Operator

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

Jeffrey Hammond - KeyBanc Capital Markets

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

Mike Lamach

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

Operator

All right. We can take Steve Tusa with JPMorgan.

Steve Tusa - JPMorgan

Congratulations, Bruce, and we were missing on these calls. I am just kidding. So, can just guys walk through maybe I do mean that, but I just wanted to may be, walk through more on the commercial HVAC given that's obviously a massive lever for your company, I mean, almost 40% of your business is related to commercial HVAC. And it is interesting that you guys collaborated with Carrier talking about a North America business up high single-digits.

It seems like the turn is coming a little sooner than expected. You mentioned unitary was flattish, I guess. Was that in orders or was that in shipments? I guess the quick turn business or maybe its both?

Mike Lamach

We haven't seen the flatness yet in orders, but I would tell you that the trending is looking positive. And when I was answering Bob's question, when we were trying to call a bottom here, it would appear that we're reaching an inflection point in orders, and that's not along slight slip for us.

Typically that's going to be usually within a quarter, but a little bit might slip four months, from initial order, but relatively quick turnaround. Applied, we had plants in China, certain of our compressor plants were 100% wide open full capacity. Phenomenal activity going through those plants, both in terms of orders, ships, and obviously the activity going through the component plants applying those were strong as well. So that was a real positive for us.

Steve Tusa - JPMorgan

So then what was applied in the US orders, orders or shipments, either one?

Mike Lamach

Yeah. So applied, much closer to breakeven at this, okay, than unitary, ahead of unitary. Unitary would be kind of high single-digit negative applied approaching low single-digit, okay.

Steve Tusa - JPMorgan

So what is driving that? Is that building owners, government incentives, spurring building owners, I mean, it just seems a little bit early given what we're seeing in commercial real estate and the financial metrics in commercial real estate so if you can say that...?

Mike Lamach

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

Steve Tusa - JPMorgan

Just talking about the applied cycle, last cycle was not that great. Everybody talks about pent-up demand in residential. Do you think there is any pent-up demand on the applied side, given that this installed base of chillers is now 10 years older than it was last cycle and maybe you're getting into the heart of the commercial real estate boom of the late 80s and the 90s? Have you looked at that at all?

Mike Lamach

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

Steve Tusa - JPMorgan

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

Mike Lamach

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

Steve Tusa - JPMorgan

No, just in general, total commercial equipment.

Mike Lamach

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

Steve Tusa - JPMorgan

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

Mike Lamach

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

Steve Tusa - JPMorgan

But not the sales volume?

Mike Lamach

Right.

Steve Tusa - JPMorgan

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

Bruce Fisher

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

Operator

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

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Source: Ingersoll-Rand Co. Ltd. Q2 2010 Earnings Call Transcript
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