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Lennox International Inc. (NYSE:LII)

Q2 2014 Earnings Conference Call

July 21, 2014 09:30 ET

Executives

Steve Harrison - Vice President, Investor Relations

Todd Bluedorn - Chairman and Chief Executive Officer

Joe Reitmeier - Chief Financial Officer

Analysts

Jeff Hammond - KeyBanc Capital Markets

Rob Wertheimer - Vertical Research Partners

Steve Tusa - JPMorgan

Keith Hughes - SunTrust

Rich Kwas - Wells Fargo Securities

Robert Barry - Susquehanna

Drew Venker - Morgan Stanley

Walter Liptak - Global Hunter

Mark Douglass - Longbow Research

Samuel Eisner - Goldman Sachs

Glenn Wortman - Sidoti

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Second Quarter 2014 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. (Operator Instructions) As a reminder, this call is being recorded.

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

Steve Harrison

Good morning. Thank you for joining us for this review of Lennox International’s financial performance for the second quarter of 2014. I am here today with Chairman and CEO, Todd Bluedorn; and CFO, Joe Reitmeier. Todd will review key points for the quarter and Joe will take you through the company’s financial performance and outlook.

Financial results in prior periods have been revised to reflect sold businesses and discontinued operations. 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 website at www.lennoxinternational.com. We will archive the webcast on that site and make it available for replay.

We would like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risk and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risk and uncertainties, see Lennox International’s publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

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

Todd Bluedorn

Thanks, Steve. Good morning and thanks everyone for joining us. In the second quarter, Lennox International grew revenue of 6% at constant currency. EBIT margin expanded 70 basis points to a record 12.3% and adjusted EPS from continuing operations was up 15% to a record $1.51.

The company’s performance in the second quarter continued to be led by our Residential business. Residential revenue was up 11% at constant currency and profit rose 28% to a record $85 million. Revenue from both replacement and new construction business was up double-digits from the prior year quarter. Our new construction business had a solid recovery in the second quarter, after being down in the first quarter from the severe winter. In addition to capturing price, we continue to see a richer product mix with 14 SEER and above products comprising 37% of cooling product shipments in the second quarter, up 1 point from the prior year quarter. Our 22 products were 11% of cooling product shipments flat with the prior year quarter.

In Commercial, revenue was up 5% at constant currency and profit rose 13%. Our Commercial business set a second quarter record for sales, margin and profit. North America commercial equipment revenue was up low double-digits on continued growth in both planned and emergency replacement business. We also saw a strong rebound in commercial new construction with mid-teen growth in the second quarter. On the national account front, we won 10 new customers in the second quarter to total 21 in the first half alone. In Europe, commercial HVAC revenue was down high single-digits at constant currency, still impacted by the uncertain geopolitical environments in Eastern Europe.

In Refrigeration as expected, market conditions remained challenging. The upside that we are realizing in Residential, Commercial is being dampened by Refrigeration, where our North America supermarket and Australia wholesale businesses have been weak. Refrigeration revenue was down 6% at constant currency. Refrigeration profit was down 47% from the record level in the second quarter a year ago.

Looking at revenue at constant currency by region, Asia and South America were up low-double digits. Europe was up high single-digits, Australia was down mid single-digits and North America was down low double-digits. Looking ahead for North America, we have been successful in wining in new National Account business that are scheduled to ramp up through the second half of this year and into 2015. In the first half of the year we have been making investments and positioning our operations to support this new business and other future growth opportunities.

In Australia economic conditions remained soft. But the larger issue has been the uncertainty around the carbon tax repeal. With the repeal of the carbon tax, we expect improvement in our refrigeration equipment business in the second half of this year following several quarters of it being on pause as customers waited for more clarity on the issue. However, the repeal and associated lower prices for refrigerant will negatively impact our wholesale refrigerant business. Overall, we expect a profitability of our Australian business to be down in the second half of the year against the second half last year.

To update you on our strategic initiatives, in residential I previously mentioned that we are transferring certain furnace production from the United States to Mexico and are also insourcing sheet metal fabrication as part of our Mexican operations. We expect $15 million in annualized savings from this initiative by 2016. Saltillo plant [2] [ph] began furnace production on June 16, one year to the day from groundbreaking. After completing process and production qualification the plant began shipping units into distribution network in early July. We are currently operating on two shifts and are well into the ramp up towards this year’s peak heating season. In our Residential distribution expansion initiative we opened up 10 new Lennox PartsPlus stores in the second quarter to bring our total stores to 150. With 50 new stores opened in the first half, we are tracking well to our target to open 25 new locations this year and exit the year at 160 stores.

In our Commercial distribution expansion, we opened up a new regional distribution center in Laredo, Texas to bring the total of dedicated commercial locations to 33. In addition, we continued to move Commercial products into select Lennox PartsPlus stores. On the Commercial service side of the business we have added two more National Account Services branches to bring the total to 84 locations supporting National Accounts across North America. And the last point in commercial, in July, we entered the VRF market in North America as planned. Our partnership with Midea is going well as we launched Lennox branded VRF Commercial products through Lennox company-owned distribution. We are excited about our opportunities in this fast-growing $500 million market in North America.

In the first half of the year across all our businesses we made significant investments to drive future growth. With a strong balance sheet and cash generation, we will continue to invest in the future, grow dividends with earnings and repurchase stock. In the second quarter, we have raised the dividend 25% to $0.30 per share quarterly. We bought back $50 million of stock in the quarter and plan to repurchase $100 million more of stock in the second half.

Now I will turn it over to Joe.

Joe Reitmeier

Thank you, Todd. Good morning everyone. I will provide some additional comments and financial details on the business segments for the quarter starting with Residential Heating & Cooling. In the second quarter, revenue from Residential Heating & Cooling was $528 million, up 11%. Currency was neutral. Volume was up 10%. Price and mix combined was up 1%. Residential profit in the second quarter was a record $85 million, up 28% from the prior year quarter. Segment profit margin was a record 16.1%, up 220 basis points. Segment profit was positively impacted by higher volume, lower material costs, lower SG&A and favorable price. Partial offsets included a less favorable warranty reserve adjustment than in the prior year quarter and investments in distribution expansion.

Turning to our Commercial Heating & Cooling business, in the second quarter Commercial revenue was $241 million, up 5%. Currency was neutral. Volume was up 5% and price and mix combined was flat. North American Commercial HVAC equipment and service revenue was up high single-digits. Europe Commercial HVAC revenue was down low single-digits on a reported basis. Commercial segment profit in the second quarter was $39 million, up 13% from the prior year quarter and segment profit margin was 16.2%, up 110 basis points. Segment profit was positively impacted by higher volume, favorable pricing mix and lower material costs. Partial offsets included investments in distribution expansion and startup cost to enter the VRF market in the third quarter in North America.

In our Refrigeration segment, revenue in the second quarter was $192 million, down 7%. Currency had a negative 1 point impact. Volume was down 6%. Pricing mix combined was flat on a revenue basis. Todd mentioned the revenue change by region at constant currency. At actual currency, Europe and Asia were both up low double-digits. South America was up low single-digits and North America and Australia were both down low double-digits. Segment profit was $14 million, down 47% from the record level of the prior year quarter.

As Todd mentioned, the weakness in the second quarter was from the North America Refrigeration and to a lesser degree Australia. Segment profit margin was 7.1%, down 530 basis points. Segment profit was negatively impacted by lower volume, unfavorable mix, investments to support future growth and foreign exchange partially offset by lower material costs.

Looking at special items in the second quarter, the company had total after-tax charges of $300,000 net. This includes a gain of $500,000 for the net change in unrealized gains on unsettled futures contracts and a charge of $500,000 for restructuring activities at a net charge of $300,000 for other items. Corporate expense was $19 million in the second quarter, down from $21 million in the second quarter a year ago. Overall, SG&A was $149 million in the second quarter, down $2 million from the prior year quarter on lower incentive compensation as planned. Cash from operations was $52 million in the second quarter compared to $49 million in the prior year quarter. Capital spending was $24 million, up from $11 million in the second quarter a year ago as the factory expansion in Mexico was completed. Free cash flow was $28 million compared to $38 million in the prior year quarter.

Looking at liquidity, cash and cash equivalents were $50 million at the end of June. Our debt to EBITDA ratio was 1.6 ending the quarter within our targeted range of 1 to 2 times. Total debt was $607 million at the end of June.

Before I turn it over to Q&A, I will review our outlook for 2014. With half the year behind us, we are raising our assumption for North American residential HVAC shipments from mid single-digit growth to high single-digit growth for the industry. We are maintaining our assumption for North America commercial unitary shipments to be up low single-digits and we still expect refrigeration shipments to be flat globally for the industry in 2014. Based on the underlying market assumptions and the company’s performance year-to-date and current outlook, we are raising our revenue guidance for the full year from 2% to 6% to a range of 5% to 7%. We still expect foreign exchange to have a negative 1 point impact.

Looking at our other guidance points for 2014, we still expect about $30 million of savings from our sourcing and engineering led cost reduction programs for the full year. We continue to expect $10 million for favorable mix in residential in 2014 and we still expect $10 million from favorable price for the full year. We now expect commodities to be flat in 2014 versus prior guidance of a $5 million headwind.

Among the headwinds for the year, we expect a negative $10 million impact from foreign exchange that will not be offset by price in 2014. In our Australian business, we expect a negative $10 million impact in the second half versus the prior year period with the repeal of the carbon tax in that country. In 2013, we benefited from the expansion of refrigerant operations in our wholesale business, including some one-time purchases of lower cost refrigerant that we sold at higher prevailing market prices. With the repeal of the carbon tax, we expect market prices to decline negatively impacting profitability in that part of the business. Corporate expense is still expected to be approximately $70 million for this year, down $18 million from 2013.

A few other guidance points. We expect net interest expense for the full year of about $15 million. Our effective tax rate is still expected between – to be between 34% and 35% on a full year basis. We still planned a total of $150 million in stock repurchases and the weighted average diluted share count for the full year is expected to be approximately 49 million shares. We continue to expect capital expenditures of $90 million. And finally, to wrap up, we are narrowing our 2014 guidance for adjusted EPS from continuing operations from a range of $4.20 to $4.60 to a range of $4.30 to $4.50.

And with that, let’s go to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) And we will begin with the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Jeff Hammond - KeyBanc Capital Markets

Hey, good morning guys.

Todd Bluedorn

Hey, Jeff.

Joe Reitmeier

Hi, Jeff.

Jeff Hammond - KeyBanc Capital Markets

Maybe just to go into the Refrigeration issues a little bit more, I mean, I guess I think of your business as kind of having 30% incremental, decrementals, obviously a lot higher here. So, can you kind of delve into what were the big drivers maybe outside of your normal decrementals?

Todd Bluedorn

Yes. Let me sort of ramble a little bit broadly about Refrigeration, Jeff. As Joe talked about and I spoke about in the script, the major driver of margin compression was North America weakness, particularly in supermarkets. Revenue was down low double-digits and so we had volume impact, but we also had a negative mix shift with some major national account customers moving towards in our KW business cases versus systems and we make higher margins on systems versus cases. We also made investments during the quarter to support the ramp up we expect in the second half of the year. In our traditional business in North America, our Heatcraft business, we have our backlogs up double-digits from this time last year. And we also won a large part of the new business from Wal-Mart at our Kysor/Warren business, which we have had to make some investments in our factory to be able to support in the second half of the year. In Q3 and more so in Q4 as the volume starts to flow, we will expect that profit performance in North America will improve.

The second reason for weakness in Refrigeration in Q2 was Australia, where revenue was down 5% at constant currency and down 10% as reported, whereas North America was the primary reason for the refrigeration weakness in the first half, Australia will be the primary refrigeration headwind during the second half. As Joe talked about, we expect a negative $10 million impact in the second half versus the prior year period with the repeal of the carbon tax in Australia. As Joe discussed in 2013, we benefited from the expansion of refrigerant operations in our wholesale business, including some one-time purchases of lower cost refrigerant that we sold at higher prevailing market prices. With the repeal of the carbon tax, we expect market prices to decline negatively impacting profitability in that part of the business.

Jeff Hammond - KeyBanc Capital Markets

Okay, that’s helpful. And then margins in the second half for Refrigeration, I mean, are they closer to kind of the second half last year or closer to first half this year?

Todd Bluedorn

We are still going to have some pressure during the second half of the year in margins. I think fourth quarter will look better than third quarter. I think North America will look better second half of the year than first half of the year, but I think the headwind from Australia will have an impact on the overall margins.

Jeff Hammond - KeyBanc Capital Markets

Okay. And then just kind of final question on incrementals very good in Commercial Heating & Cooling and Residential, maybe just talk about sustainability as you think about some of these seemingly within your initial guidance, I think a lot of your savings was more back half weighted. So, just talk about incremental momentum in those businesses?

Todd Bluedorn

Are you talking for the second half of the year or longer?

Jeff Hammond - KeyBanc Capital Markets

Yes.

Todd Bluedorn

Yes. I mean, I think two out of the three businesses have strong momentum both on revenue, on margin expansion. That’s going to continue in the second half of the year. The headwind obviously is Refrigeration, I signaled that we are going to have margin pressure second half. Our initial guidance when we started the year was 30% incrementals as we have raised revenue and sort of kept the bandwidth around the midpoint being the same. We are now signaling given some of the headwinds in Refrigeration that our margin [drop] [ph] to maybe close to 30%, but I think about it between 25% and 30% is sort of what we are signaling for this year. Over three years, we still think it’s going to be 30% as we sort of get through this rough spot in Refrigeration.

Jeff Hammond - KeyBanc Capital Markets

Okay, thanks a lot.

Todd Bluedorn

Thanks.

Operator

All right. And next we will go the line of Rob Wertheimer with Vertical Research Partners. Please go ahead.

Rob Wertheimer - Vertical Research Partners

Hi, good morning guys. Just wanted to – and then obviously the Resi results and the Commercial were great too. I just wanted to focus a little bit on the bifurcation between Refrigeration and Commercial. I am curious as to whether you saw Refrigeration as a market issue or really a share issue or maybe a little bit of a timing issue, but is there a differential desire to spend capital on your Commercial customers versus your Refrigeration and/or are you just losing share in Refrigeration right now?

Todd Bluedorn

I think there is a bit of a difference in the customer base. In the sense of, in our HVAC equipment I think there is increasingly, has been an increasingly compelling reason for customers to accelerate to switch out for energy efficiency reasons, I think number one. Number two is I think the grocery segment has had slower growth than some of the other verticals that we play in, in big box retail and light industrial even in schools. But I think the honest answer is especially in KW as I have spoken about before, I don’t think we are losing share with individual customers, I think it’s the customers who we have traditionally done business with aren’t growing as fast as the overall market, which means you’ll lose share if that happens. And we have been focused on adding to our customer base. And I mentioned we got a nice order from Wal-Mart that we think is going to help second half of the year. But I think that’s sort of the fundamental issue in North America volume.

Rob Wertheimer - Vertical Research Partners

Okay, that was helpful. Thank you. And then just one quick question on pricing in those two markets, anything dramatic going on in Refrigeration pricing and you mentioned the mix issue just a moment ago on the pricing side?

Todd Bluedorn

No, pricing, we passed on a price increase and we are getting price in the marketplace.

Rob Wertheimer - Vertical Research Partners

Great. Thanks a lot.

Todd Bluedorn

Thanks.

Operator

And next we will go to the line of Steve Tusa with JPMorgan. Please go ahead.

Steve Tusa - JPMorgan

Hey, good morning.

Todd Bluedorn

Hi Steve.

Steve Tusa - JPMorgan

So the $10 million that you called out I am just want to kind of understand the trajectory on Refrigeration side for the second half, I mean is that the major headwinds which we look at second half last year to second half this year and think of $10 million as the starting point and then kind of factor in some other stuff, is that just this 7% that you did this quarter is obviously going to get better, but I think it would just be helpful to get a little bit of a magnitude around what the second half could look like, so you can at least baseline it so we can reset the bar here?

Todd Bluedorn

I would start with $10 million and then…

Steve Tusa - JPMorgan

Okay.

Todd Bluedorn

And then in North America, I am signaling that we are going to have – while we are going to get better, we are still going to have some margin pressure in second half in North America, although the rate of deceleration is going to be slower in second half than first half.

Steve Tusa - JPMorgan

Okay. Got it. And as we look out to the three year plan now in Refrigeration, I think the guide is 13% to 15% in margin, I mean obviously, that looks like a pretty dramatic stretch at this stage of the game, how do we think about kind of the levers over a multi-year period here, I mean is this now just a structurally lower margin business?

Todd Bluedorn

No, I don’t think so, Steve. Still we may not get to 15%, but I still think 13% within our sights. We ended last year at about 10%. We are going to be down obviously this year, given where we are first half of the year. But as we get volume to flow back through our North American business, we get to the other side of this dislocation due to the carbon tax in Australia. We continue to make momentum in our European business. Brazil continues to do well. I think we are still targeting that – at least a 13% over the three-year period. I mean I reflect about where we were, it’s not exact same analogy, but back in 2011 we had severe mix down in Residential. Our margins went down dramatically. There were some severe concern about what we were going to be able to do there and here we sit two and a half, three years later and we are in great position in Residential. I think you get to the other side of these mix issues, you get to the other side of volume issues, things look a lot better and I think that we will do that in Refrigeration.

Steve Tusa - JPMorgan

Right. So I guess my point is if you look out to that, I mean does that mean ‘15 is a snapback year or you are kind of, it’s pretty back end loaded, there is a lot of kind of heavy lifting to do, that’s just what I am trying to get my arms around I guess?

Todd Bluedorn

I don’t – I think we have put in place a lot of the initiatives whether it’s material cost reduction factories, getting everything ready, what we need is some volume and mix to head the right direction which is based on customers. And we are getting that in place. And I am not going to signal necessarily on ’15, but I think we have a three year plan to get the margins to 13% in Refrigeration.

Steve Tusa - JPMorgan

And did you win the Kysor/Warren thing was that one from the incumbent at Wal-Mart?

Todd Bluedorn

I think all three of us got business and so it was just sort of reshuffling and we ended up with more than what we had before.

Steve Tusa - JPMorgan

Okay. And then one last question just on Residential, what kind of benefit I guess on the margin was mixed – on the margin improvement?

Todd Bluedorn

I am trying to – I am looking around the room to say if we called it out. It’s less than 2%. Yes. We have positive mix of 1% or 2% for the quarter.

Steve Tusa - JPMorgan

On the margin as well?

Todd Bluedorn

Yes.

Steve Tusa - JPMorgan

I mean, so why would that be any different as the transition comes through next year?

Todd Bluedorn

Ask the question again, Steve.

Steve Tusa - JPMorgan

Why would that benefit be – would the margin benefit for any reason be different next year if the mix goes up materially with the 14 SEER transition?

Todd Bluedorn

Yes, because the pricing on 14 SEER post regulation will be lower than the pricing in 14 SEER pre-regulation, because all of a sudden when you make it the minimum efficiency that becomes the battleground over pricing. So, I know the – all of a sudden when half your business goes from 13 SEER to 14 SEER in the south, you don’t get the full margin impact, we will get some impact, but pricing will be – that will become the battleground for pricing.

Steve Tusa - JPMorgan

And you think that happens that quickly over, I mean, in 13 SEER that didn’t, I mean it took a while for that the 10 SEER to 13 SEER, it took a while for that price to come down. I mean, is that – would you expect that to happen in ‘15 or is that more like a ‘16, we talked about more of a normalized kind of longer term dynamics?

Todd Bluedorn

I think it happened recently quick, last time. And we will guide on ‘15. What you are suggesting is there is some upside, there probably is, I don’t disagree with that.

Steve Tusa - JPMorgan

Okay, great. Thanks a lot.

Todd Bluedorn

Thanks.

Operator

Alright. And next, we will go to the line of Keith Hughes with SunTrust. Please go ahead.

Keith Hughes - SunTrust

Thank you. A couple of questions. Back to Refrigeration, how much does Australia represent of that segment since?

Todd Bluedorn

25%.

Keith Hughes - SunTrust

Has that been a constant number or has it come up in the last couple of years?

Todd Bluedorn

Full order of magnitude constant, I mean, after we did the KW acquisition, it went down, but 25% has been about where it’s been since we did KW.

Keith Hughes - SunTrust

And switching back to Residential as we are sitting now at $164 million plus by the end of this year, you have any early views for ‘15 and what that number will do?

Todd Bluedorn

What we said was 2016 will have 215 stores. I just sort of lay the math out and think about it as a linear, which is 25 to 30 a year. So, I guess that it means we will have 185 to 190 in 2015, but we will give an exact number in December.

Keith Hughes - SunTrust

You think as you approach that goal, will the magnitude of the ad from each location start to go down as you get this network more filled out.

Todd Bluedorn

I mean, theoretically at some point we will reach diminishing returns, but we haven’t hit them yet. I think I saw transcript from Watsco’s note or Watsco’s call, I think they should have 570 locations and we have a larger geographical footprint than they do. So, I think we have ways to go.

Keith Hughes - SunTrust

Okay. And then finally in Commercial, any sort of view in the second half of the year in the United States, any sign from customers accelerating, decelerating just with the quality of orders?

Todd Bluedorn

I mean, we had a good second quarter, right. So, we are up double-digits both in new construction and in replacement. And so the momentum is pretty good in the Commercial business. So, I don’t know if I think about it as accelerating or decelerating, I think it’s if we continue where we are at in second quarter, that’s a nice little run rate.

Keith Hughes - SunTrust

Good as it has been, I guess. Alright, thank you.

Operator

Alright. And next we will go to the line of Rich Kwas with Wells Fargo Securities. Please go ahead.

Rich Kwas - Wells Fargo Securities

Hi, good morning everyone. Just a follow-up on the Refrigeration, so as it relates to the $10 million for the second half of the year, does that – should we think of it that there is some sleep over into the first half or does that pretty much dissipate into the first half of ‘15?

Todd Bluedorn

Ask the question one more time, Rich. I think I understood.

Rich Kwas - Wells Fargo Securities

You got a $10 million headwind here in the second half of the year, so do we think of that as dissipating once the calendar turns or is there still some leakage there in terms of the negative profit impact?

Todd Bluedorn

There will be some leakage in the first half of next year.

Rich Kwas - Wells Fargo Securities

Okay. But should we think of that as kind of materially less than the $10 million or is that still kind of be close to that run rate?

Todd Bluedorn

I think it would be less than $10 million and we will have good news to help offset it, right. So, I wouldn’t sort of get too nervous about 2015, we will guide to 2015 in December, but yes, that’s – we will have some headwind in Australia first half of the year from refrigerant.

Rich Kwas - Wells Fargo Securities

But then ostensibly the North American business is picking up as well, is that starting here – the incremental business starts second half of the year?

Todd Bluedorn

Yes.

Rich Kwas - Wells Fargo Securities

Okay. And then on Resi on pricing, so it seems like all pricing is struck here year-to-date, the $10 million, I know you reiterate the guide there for $10 million, but what’s kind of the bogie in terms of upside downside scenario for the balance of the year.

Todd Bluedorn

I think part of the issue is let me talk about how we have sort of broken these buckets up is we have said that there is $10 million in net price. That ignores the FX issue that we have in Canada. And so what we have done is we have sort of raised prices in Canada help offset the FX we are getting or the translational or transactional FX issue we have in Canada and we are saying there’s still going to be a $10 million headwind. The actual FX problem we have is larger than that and we have gotten price to help offset it. So, really sort of gross wise, we have got more than $10 million of price, but net in Residential, it’s $10 million. So, I still – I think that’s probably a good number.

Rich Kwas - Wells Fargo Securities

Okay, okay. And then ostensibly the first having the few weeks here in July given that you raised the guide for North American Residential for the year, I know Q2 came in better, but we have seen trends wise certain for early stages of Q3?

Todd Bluedorn

Solid is the way I can calibrate it. I mean, and solid meaning continuing with what we have seen over the last year or so. First couple weeks were a little cooler than last year down about 10% from last year, but last August was at least for the summer compared to the rest of summer was a cool August. So, net-net, we are not worried about the weather yet and momentum continues.

Rich Kwas - Wells Fargo Securities

Okay, thank you.

Todd Bluedorn

Thanks.

Operator

And next we will go to the line of Robert Barry with Susquehanna. Please go ahead.

Robert Barry - Susquehanna

Hey, guys. Good morning.

Todd Bluedorn

Hey, Robert.

Robert Barry - Susquehanna

Very quick follow-up on that last comment, when you said down 10% in the first couple weeks, is that cooling degree days?

Todd Bluedorn

Yes.

Robert Barry - Susquehanna

Okay. And I guess sticking on the topic of weather, I mean, was a real headwind in the first quarter, especially with R&C. I mean, did you see any push or volume benefit in Resi and/or Commercial in this quarter because of push from 1Q?

Todd Bluedorn

I think what we saw was what we expected to see in the sense of we call that we thought Residential was going to – new construction was going to snapback. We saw it up double-digits in first quarter. We saw new construction and commercial up double-digits. I think in Commercial, it was less about the weather. I just think that’s momentum in the Commercial market. I think Residential was some snapback from first quarter.

Robert Barry - Susquehanna

Did you see how much the growth was in the emergency replacement piece or could you in Commercial?

Todd Bluedorn

Yes. It was up low single-digits the second quarter against the comp of second quarter ‘13 when we first began the rollout of the rooftop. And so the way I think about it is last year we were up 14% as we sort of loaded the barns with our distribution is up low single-digits second quarter this year. And then over the last 12 months, we have been up double-digits. So, the momentum in emergency replacement continued in second quarter.

Robert Barry - Susquehanna

I think this quarter though is also when you started rolling out kind of the expanded line of larger units in Commercial, is that just smaller than what was rolled out initially?

Todd Bluedorn

Short answer is that it was rolled out mid-May and so it had some impact this quarter, but I think we will really start to see the impact in third quarter from the expansion.

Robert Barry - Susquehanna

Okay. And then just finally on the SG&A, I know you guys kind of target over time at tracking, at growing half the rate of sales, I think year-to-date is actually down, even though you have had a lot of growth investment, maybe some of that is the incentive comp. I mean, how should we think about the way that’s been tracking and how it will track just given its generally targeted at half the rate of sales?

Todd Bluedorn

I think this year I’d sort of model it to be down half the rate is what you suggested. As you recall last quarter, we had I think we are down $8 million or $9 million corporate expenses versus last year and that was SG&A and that was incentive comp. And we said, our total corporate expenses will be down $18 million full year and a large piece of that is incentive comp. So, short answer is I think modeling half the rate of growth is probably the right number.

Robert Barry - Susquehanna

For the back half, so it will kind of start to tick up?

Todd Bluedorn

Yes, it will tick up largely associated with the timing of incentive compensation and sort of the profit curve that we used to report and record those costs.

Robert Barry - Susquehanna

Okay, great. Thank you.

Operator

And next we will go to the line of Nigel Coe with Morgan Stanley. Please go ahead.

Drew Venker - Morgan Stanley

Yes, hi, guys. Good morning. It’s Drew on for Nigel.

Todd Bluedorn

Hi Drew.

Drew Venker - Morgan Stanley

I just want to dig into the inventory a little bit, I know you had mentioned last quarter that if there was pre-build in advance of the SEER standard change that would come in the fourth quarter, have you guys seen any of that yet or able to quantify it?

Todd Bluedorn

The answer is, the regulations around enforcement are still up in the air, so we are still waiting for some clarity there. We are meeting with our distribution partners and our dealer customers and we are fine tuning what we are going to do. We will bring more clarity to that most likely on the third quarter call.

Drew Venker - Morgan Stanley

Okay. And then in Commercial, now that you are in the market on the VRF, should we assume that all of the investment headwind is now through and that it was the full 5 million?

Todd Bluedorn

We got it last time between 3 million to 5 million. We are still in investment mode in second half of the year. While we started selling, it’s a long lead time just sort of to get the business closed. So I would think about it as I would spread it over the full year broadly speaking linear. And then next year front end will still be investment mode, second half will start making money and next year I think about it as being sort of neutral and then we start making money in 2016, that’s how I think about it.

Drew Venker - Morgan Stanley

Okay, got it. That’s helpful. And then on Resi you brought up the market growth estimate, are you able to quantify what your share gains are at this point or just maybe year-to-date?

Todd Bluedorn

We don’t publicly sort of quantify AHRI numbers public about what the industry is doing and we give our number and we let you all calculate it?

Drew Venker - Morgan Stanley

Okay. Got it. Thanks.

Todd Bluedorn

Thanks.

Operator

And next we will go to the line of Walter Liptak with Global Hunter. Please go ahead.

Walter Liptak - Global Hunter

Hi. Thanks guys. Just a couple of follow-ups, first on the last question with pre-build in the fourth quarter, so you are saying that if that you were to be a pre-build that would be incremental to the guidance, so right now there is no pre-build and are your formula…?

Todd Bluedorn

I mean I think about pre-build as the way it will impact the guidance will be on cash flow. So if we are building inventory that we are then going to sell in 2015, we just carry more inventory going into end of the year.

Walter Liptak - Global Hunter

Okay. Go it. And then in the Refrigeration market, you called out some investment into future growth, I wonder if you can provide some more color and is that new to the guidance or is that something that was already in for 2014?

Todd Bluedorn

It’s business that we won during the year and the customer is Wal-Mart. And so we are expanding the factory adding people sort of getting ready to handle the business.

Walter Liptak - Global Hunter

Okay. Thanks very much.

Todd Bluedorn

Thanks.

Operator

And next we will go to the line of Mark Douglass with Longbow Research. Please go ahead.

Mark Douglass - Longbow Research

Alright. Good morning gentlemen.

Todd Bluedorn

Good morning.

Mark Douglass - Longbow Research

In Commercial can you talk a little more broadly about what the market is doing, I mean your place was good for you but that’s relatively new, but you said new construction was up mid-teens, is it something regional that you are seeing that maybe benefits you or is it overall that you are seeing a nice pickup and you expect that to – through a continue the non-resi construction pickup that everybody has been talking about is hopefully coming?

Todd Bluedorn

Yes, I mean, I am not trying to make a call on the broader macro call of non-resi, which implies a lot of verticals we don’t play in. So what we are saying is in unitary North America where we play which is half of our businesses is retail movie – theaters, schools we were up double digits in new construction. So I think that’s more reflection on the verticals that we play than necessarily a broader non-resi call.

Mark Douglass - Longbow Research

Okay. But retail was up in new construction?

Todd Bluedorn

We were up double digits in new construction and half of our businesses is with retail. The industry year-to-date is up low-single digits, I think we are winning share and outperforming the industry.

Mark Douglass - Longbow Research

Okay. Great. And then just one last question with the Saltillo coming online, what do you have as far as expected net benefit in ‘14 and we talked about the overall savings you expect by ’16, is there much coming in the second half?

Todd Bluedorn

No, I mean it’s a net expense for us I mean, so we think it’s about $5 million headwind. As you can imagine, we staff up and build a factory and it takes time to ramp up, so we are under absorbing. So, it takes a while. And so it’s a headwind that’s always been in our guidance.

Mark Douglass - Longbow Research

Okay, but the absorption will come in ‘14, I mean in ‘15 excuse me?

Todd Bluedorn

Yes, I mean, I think about it as you know we have said ‘16 is $15 million. In 2015, it will be a positive number somewhere between negative plus $15 million and we will guide in December probably on what that number is. And then in 2016, we enter the year at the full $15 million.

Mark Douglass - Longbow Research

Okay, thank you.

Todd Bluedorn

Thanks.

Operator

Next, we will go to the line of Samuel Eisner with Goldman Sachs. Please go ahead.

Samuel Eisner - Goldman Sachs

Yes, good morning everyone.

Todd Bluedorn

Good morning.

Samuel Eisner - Goldman Sachs

So, just going back to Refrigeration, I think you said about $10 million year-on-year headwind in the back half of the year, how is that split between third and the fourth quarter?

Todd Bluedorn

I broadly go spread at linear.

Samuel Eisner - Goldman Sachs

Okay, great. And then in terms of the mix headwinds that you talked about moving away from systems into cases, did you quantify how much of a headwind that was on a year-on-year basis either in dollar terms or in percentage basis?

Todd Bluedorn

We didn’t, but I would say it’s $2 million or $3 million for the quarter.

Samuel Eisner - Goldman Sachs

Great, thanks. And then I think Todd you mentioned that your backlog was up about double-digits or so in Refrigeration presuming that reflects the Wal-Mart order, but just curious kind of margins in the backlog are looking as it’s been today and what’s the expectation for that backlog starting to hit the P&L?

Todd Bluedorn

KW business, which is driven by Wal-Mart, but also in our traditional what we call HRP HeatCraft Refrigeration Products in North America is up double-digits, which isn’t Wal-Mart business, it’s sort of broader business. We think the margin of the business will – in North America will be better second half than it was first half.

Samuel Eisner - Goldman Sachs

Got it. And then just lastly on just overall cost savings and margins, I mean the revenue was really strong this quarter, curious how that carried into the back half of the year, should we continue to expect about 20 plus basis points of margin expansion and I guess what’s the view on kind of sourcing savings coming forward?

Todd Bluedorn

We are still calling 30 million of sourcing savings. Initially, we called for it to be back half loaded. We were able to accelerate some things and sort of over-performed first half and so we now think it’s probably 50:50 first half, second half. And we continue to have margin expansion opportunities in residential, I am not sure, we are going to be up 200 basis points every quarter like we were in second quarter, we weren’t in first quarter. So, I think about while we expand that first half of the year and that’s probably a fair put to think about second half.

Samuel Eisner - Goldman Sachs

Great, thanks so much.

Operator

Alright. And next we will go to the line of Glenn Wortman with Sidoti. Please go ahead.

Glenn Wortman - Sidoti

Yes, good morning guys.

Todd Bluedorn

Hey, Glenn.

Glenn Wortman - Sidoti

Yes, on your resident new construction business and given the sort of relatively weak housing data out there, I was surprised on the strength you saw. Do you think you outperformed the industry or is that snapback more market based on your view?

Todd Bluedorn

I think both are probably true. As we have said, we have an outsized position with the big builders. We thought weather had pushed some volume from first quarter to second quarter. And then there is sort of mix data. I mean, I know the starts were sobering, but also builder confidence is at record highs. So, I think there is some conflicting data out there. As the year started, we called for new construction. We have 10% on a full year basis. We still think that’s probably the right number.

Glenn Wortman - Sidoti

Okay. And is that part of your business performing well into the third quarter?

Todd Bluedorn

It’s early, but momentum that we saw in second quarter we are seeing in third quarter across the business.

Glenn Wortman - Sidoti

Okay, alright. Thanks for taking my questions.

Todd Bluedorn

Excellent.

Operator

Great. And next we will go to the line of Steve Tusa with JPMorgan. Please go ahead.

Steve Tusa - JPMorgan

Hey, guys. Just a follow up, the comment on weather in July, what are you guys seeing in July, I mean, your business up kind of around what you did in the first half, maybe just some context around that?

Todd Bluedorn

Yes, I mean, it remained – the short answer is it remains solid in the momentum we saw first half of year we are seeing in third quarter. I just make the point that weather is 10% cooler and we’d rather have a big moment. And just to your point throwing that adds a little bit of a warning, but as I suggested we are off to a solid start. And September is our biggest month in the quarter. So, we got lot of work still in front of us.

Steve Tusa - JPMorgan

Right. And pricing is holding okay in the channel?

Todd Bluedorn

Correct.

Steve Tusa - JPMorgan

Okay, great. Thanks.

Todd Bluedorn

Good.

Operator

There are no further questions.

Todd Bluedorn

Great, thanks. A few other guidance – I am reading the wrong script, let me get to the right script. A few points to leave you with. The company had record profit on record total segment margin in the second quarter, but we are on track for strong growth in record profitability for the full year. Residential and commercial are performing to the upside, while Refrigeration is choppy in 2014. Overall, we are raising guidance for company revenue growth, up 5% to 7% this year with 16% to 22% growth in adjusted EPS from continuing operations. We look forward to the rest of the summer season and a strong second half of the year. Thank you for joining us.

Operator

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

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Source: Lennox International's (LII) CEO Todd Bluedorn on Q2 2014 Results - Earnings Call Transcript
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