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Lennox International Inc. (NYSE:LII)

Q3 2011 Earnings Conference Call

October 25, 2011 9:30 AM ET

Executives

Steve Harrison – VP, IR

Todd Bluedorn – CEO

Bob Hau – CFO

Analysts

Jeffrey Hammond – KeyBanc Capital Markets

Josh Pokrzywinski – MKM Partners

Robert Barry – UBS

Adam Samuelson – Goldman Sachs

Rich Kwas – Wells Fargo Securities

Keith Hughes – SunTrust Robinson Humphrey

Steve Tusa – JPMorgan

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Third Quarter 2011 Earnings Conference Call.

At the request of your host, all lines are in a listen-only mode. There will be a question-and-answer session at the end of the presentation. As a reminder, this conference is being recorded.

I’d 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 third quarter of 2011. I’m here today with Todd Bluedorn, CEO, and Bob Hau, CFO. Todd will review the key points on the quarter and year, and Bob will take you through the company’s financial performance and outlook.

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

I would like to remind everyone that in the course of this call to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Lennox International’s publicly available filings with the SEC. Lennox 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 to call over to CEO Todd Bluedorn.

Todd Bluedorn

Thanks, Steve. Good morning and thank you all for joining us.

Let me take you through a few key points on the third quarter, and then Bob will discuss the financial results in detail and the outlook.

Total company revenue was up 13% in the quarter including the Kysor/Warren acquisition. Excluding the acquisition and cost and currency, revenue was up 2%. We saw volume growth across all our equipment businesses, with commercial and refrigeration also benefiting from improved price and mix.

Residential at favorable pricing also, but again, saw a mix down compared to a year ago. In our service business, residential revenue is down while commercial revenue was up for the quarter. EBIT margin at 7.4% was down 140 basis points. Margin was impacted primarily by higher raw and component commodity cost as well as lower mix. These were partially offset by a favorable price and a two-point improvement in SG&A as a percentage of sales. Adjusted EPS from continuing operations was $0.80 versus $0.83 in the third quarter a year ago. GAAP EPS from continuing operations is $0.64 versus $0.76 in the prior year quarter.

Looking at each business in the third quarter, let me start with residential. The uncertain consumer environment continued in the third quarter as reflected in consumer confidence, which dropped from 59 in July to 45 in August and stayed there in September. However, weather helped in the quarter.

In July, weather was both warmer than normal and warmer than last year. For the third quarter overall, cooling degree days were above normal, but in line with the third quarter last year. Residential revenue was up slightly at constant currency in the third quarter and segment margin was down 280 basis points to 7.7%. While volume and mix were up, the dynamics we have seen around mix this year continued, leading to the mix down on a year-over-year basis.

As we have talked about previously, the expiration of the Federal Tax Credit at the $1,500 for high-efficiency HVAC equipment and the re-emergence of R-22 outdoor condense units in the market have negatively impact product mix in complete HVAC system selling, both for us and for the industry, in general.

In total, for both our Lennox and Allied brands, 37% of cooling product shipments in the third quarter for 14 SEER and higher, down nine points from a year ago. Conversely, 13 SEER was 63% of shipments in the third quarter this year. R-22 was up from virtually nothing a year ago to just under 20% of cooling product shipments in both the second and third quarter of this year.

Our residential saw double-digit growth in cooling product shipments year-over-year in the quarter. Gas furnace shipments were down low single digits as the attached rate for complete HVAC system sales continued to lag.

To help offset the year-over-year headwind against complete HVAC system sales, we repacked our promotions and incentives both at the dealer and consumer levels, to encourage more complete system sales. This does not mean more dollars, but a repackaging around the promotions and incentives we always have had in the market.

We’re also well-positioned moving into the heating season with a more complete line-up of our new furnace platform across the various SKUs this year. Our new furnace in the market have been standardized on a cost-reduced 33-inch platform and range from highly competitive entry-level furnaces all the way up to most premium in the market, leading energy efficiency and performance.

It is still early in the furnace-selling season and we need a winner to set [ph] in across North America to drive volume. Our service expert business saw the same dynamics and residential as on the premium side of our residential equipment business, a mix down and fewer complete HVAC system sales. Again, we have repackaged promotions and incentives to help counter these effects and compete more effectively across the HVAC market spectrum.

In our commercial service business, we saw 6% revenue growth. Overall, for service expert segment, revenue was down 5% of constant currency and margin was down 30 basis points to 3.7%.

Turning to our commercial equipment business segment, revenue was up 10% at constant currency. We saw a broad base growth across our business in North America, led by stronger placement business at national accounts. Revenue from both our placement and new construction business was up double digits in the quarter. Favorable mix was driven by the success of our high-energy efficient rooftop, Energence and Strategos with national accounts. We won five new national accounts in the third quarter, bringing our year-to-date total to 14. Since the start of 2007, we’ve won 89 new national accounts.

Europe revenue was up low single digits at constant currency and we saw solid growth in both Western and Eastern Europe and continue to expand our geographical reach in the region. Commercial segment margin was up 30 basis points to 14.4% on favorable volume, price and mix and lower SG&A that combine to more than offset commodity headwinds year-over-year.

Now, refrigeration business for the third quarter. Revenue was up 59% including the Kysor/Warren acquisition. Organic revenue of constant currency was up 4% after adjusting for the strategic asset of the third-party coil business on Australia last year. Europe continued to lead growth with strengthened both food and non-food refrigeration runs up double digits.

Refrigeration segment margin was up 20 basis points, excluding the impact of the Kysor/Warren acquisition. Refrigeration volume growth and favorable pricing mix more than offset commodity headwind in the quarter.

Let me shift gears and talk about what we’re seeing on the commodity and component front overall and the latest on price. For 2011, we continue to expect raw and component commodity headwinds of $60 million to $65 million. We continue to capture price in the market and still expect to realize $50 million more this year over last year.

Our most recent pricing action was last week when we announced new 1% to 6% increase at our Lennox commercial business effective December 5th. Regarding cost reduction in the space, we’re still on track with sourcing savings over approximately $25 million in 2011.

Turning to 2012, let me make a few points on the year now. Then, is as our standard practice, we’ll get specific details at our annual analyst day, which will be on December 14th in New York. Looking in next year, we’re obviously facing uncertain markets, mix and commodity prices. Most important is the macroeconomic overhang, which is uncertain. Given the overall market uncertainties, we’re taking cost actions in ensuring contingency plans are in place for different scenarios that may develop.

We’ve had great success on material cost reductions over the last few years as we source more of our components from agent suppliers and created a more competitive supply base. As we have talked about before, the material cost reductions will come increasingly from platform and system redesigns that take cost out.

About nine months ago, we stepped up the engineering focus on these types of cost that cause takeout programs. We’re excited about the progress we are making and expect to have similar cost reductions in 2012 from engineering-led programs as we’ve had from moving our supply base to Asia over the last three or four years.

We have also undertaken further restricting actions at the company, including moving productions to lower cost factories and structure reductions in SG&A. We expect programs that are currently announced to provide a pre-tax benefit of $7 million in 2012. In SG&A, through combination of restructuring and closely controlling discretionary expenditures, spending will be essentially flat this year with 2010.

On a long term basis, we target SG&A to grow at half the rate of revenue growth as markets come back. One final point before I turn it over to Bob, the company has strong cash generation in third quarter with free cash flow of $132 million. We pay $10 million in dividends and repurchased $55 million of stock in the quarter. Due to the first 9 months of the year, we paid $27 million in dividends and repurchased $90 million of stock.

Given the recent stock price and the company strong cash generation, we are increasing our share repurchase plans for more than $100 million to a target of $100 million for the full year.

Now I’ll turn it over to Bob.

Bob Hau

Thank you, Todd. Good morning, everyone. Let me provide you some additional commentary in the business segments for the quarter starting with residential heating and cooling. In the third quarter, revenue from residential heating and cooling was $374 million, up 1%. Buying was up 4% mixed with down 5% and price was up 1%.

Currency had a one-point positive impact. Residential segment profit was $29 million compared to $39 million in the prior year quarter. Segment profit margin was 7.7% compared to 10.5% in the third quarter last year. Results were primarily impacted by lower mix and higher commodity cost with offsets from higher volume, price realization and lower SG&A.

Turning to our commercial unit cooling business, in the third quarter, commercial revenue was $199 million, up 13%. Buying was up 3% and price and mix were up 7%. Currency had a three-point positive impact to revenue growth. Our North American commercial HVAC revenue was up mid-teens and Europe commercial HVAC revenue was up low double digits.

Commercial segment profit was $29 million, up 15% from $25 million in the prior year quarter. Segment profit margin was 14.4%, up 30 basis points from 14.1% in the third quarter last year. Results were primarily impacted by higher volume, favorable price and mix and lower SG&A with an offset from higher commodity cost.

Moving to our service experts business. In the third quarter, revenue was $145 million, down 4%. Volume was down 7% and price and mix were up 2%. Currency had a one-point positive impact. Segment profit was $5 million compared to $6 million in the prior year quarter and segment profit margin was 3.7% compared to 4.0% in the third quarter a year ago. Results were primarily impacted by lower residential volume with offsets from strong growth and commercial services and overall lower SG&A expenses.

In our refrigeration segment, revenue in the third quarter was $224 million, up 59% including the impact of the Kysor/Warren acquisition. Adjusted for the strategic exit of the third-party coil business in Australia last year, organic revenue was up 11%, volume was up 2% and price and mix were up 2%. Currency had a positive seven-point impact.

Segment profit was $21 million compared to $17 million in the prior year quarter. Segment profit margin was 9.2% including the effect of the Kysor/Warren acquisition versus 12.3% in the third quarter last year. Excluding the acquisition, refrigeration profit margin was up 20 basis points over the prior year quarter.

Overall refrigeration results were primarily impacted by higher volume and favorable price and mix with offsets from higher commodity cost and higher SG&A including the acquisition. Looking at special items in the third quarter, the company had an after-tax chart restructuring charges of $6.7 million largely related to corporate and SG&A structural changes, as well as headcount reductions.

We expect these (inaudible) $7 million of free tax benefit and earnings in 2012. Corporate expenses were $15 million in the third quarter, flat with prior year quarter. For the full year, we now expect corporate expenses to be $55 million to $60 million versus prior guidance of $60 million.

Overall SG&A was $166 million in the third quarter, up just under 2% from the prior year quarter. For the third quarter, cash from operations was $140 million, double the $70 million in the prior year quarter. Capital spending was approximately $8 million in the third quarter compared to $10 million in the prior year quarter and free cash flow was $132 million, up 122% from $59 million a year ago.

Due to the seasonality of our business, most cash generation takes place in the second half of the year. Excluding the impact of the Kysor/Warren acquisition, working capital is a percent of trailing 12-month sales for the company was 18.5%, up from 16.7% in the year-ago period. The quarter end working capital ratio was 17.6%, down from 18.9% at the end of the third quarter a year ago as we begin to work on inventory in the second half of this year.

Looking at liquidity, cash and cash equivalence were $58 million at the end of the quarter and our debt-to-EBITDA ratio was 2.0 with total debt of $500 million at the end of the quarter. On October 21st, the company extended the maturity on its $650 million senior unsecured revolving credit facility from October of 2012 to now, October of 2016 through an amended and restated agreement.

Before I turn it over to Q&A, I’ll briefly talk about our market assumptions for the full year of 2011. In residential, we now expect industry shipments to be up mid single digits for the year in total versus our prior view of low single digits. But as we’ve discussed before, the impact of R-22 and the lower tax incentive is driving a significantly negative mix year-over-year for 2011.

We still expect the refrigeration market to be up mid single digits and we now expect the North American commercial unitary market to be up low double digits versus our previous expectation for the industry to be up high single digits. Based on these assumptions and with one quarter to go in 2011, our guidance for organic revenue for the full year is now flat up 2% including two points of positive foreign exchange impact versus the prior range of up 1% to 4%. Including the Kysor/Warren acquisition on an as-reported basis, our revenue growth guidance range is now 7% to 9% versus the prior range of 8% to 11%.

Commodity headwind in 2011, from the increases in raw and component material remains $60 million to $65 million, partially offset by $50 million of price. As Todd mentioned, we’ve announced an additional 1% to 6% price increase in our Lennox commercial business effective December 5th.

We are narrowing our 2011 guidance for adjusted EPS from continuing operations to a range of $2 to $2.15 compared to our prior range of $2 to $2.30. Including the impact of announced restructuring activities, our GAAP EPS guidance moves to a range $1.78 to $1.93 from the prior range of $1.93 to $2.23.

Our weighted average share count for the full year of 2011 is expected to be approximately 53.5 million shares and for the full year of 2011 tax rate, we now expect approximately 33.5%. Capital spending for 2011 is expected to be between $45 million and $50 million versus prior guidance or approximately $60 million.

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

Todd Bluedorn

Operator, before we go to Q&A, I’ve been informed that I got so excited about the stock repurchase plan that I misstated. So let me reread from my script the final sentence. Given the recent stock price and the company strong cash generation, we are increasing our share repurchase plans from more than $100 million to a target of a $120 million for the full year. So our target is now $120 million versus $100 million.

Okay, operator, let’s go to Q&A please.

Question-and-Answer Session

Operator

Thank you and we’ll go to Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Jeffrey Hammond KeyBanc Capital Markets

Hi, good morning guys.

Bob Hau

Hi, Jeff.

Todd Bluedorn

Good morning, Jeff.

Jeffrey Hammond KeyBanc Capital Markets

Good color on the initial thoughts on ’12 on cost savings and you made a comment, what you’ve announced thus far, are you contemplating additional actions that would get announced? And maybe just a comment on price cost as we’ve seen commodities dip down here.

Todd Bluedorn

Well, let me first talk about commodities and then I’ll talk about the cost side of the equation. As you suggested in your comments, we’ve seen commodity prices have eased some from earlier this year but have been moving around quite a bit. And as you know, we systematically hedged copper and aluminum. Such at 12 months out, we’re already around 50% hedged. Effectively, this creates a six-month (inaudible) lag between spot prices when we start to see the impact on our P&L.

Right now, our hedge positions on aluminum-copper are about 10% to 20% higher than a year ago. So, sort of where we stand out of what we already have hedged, it’s 10% to 20% higher than where stood in 2010 going into 2011. Steel is the other major commodity and while prices are down some, there’s still uncertainty. For us steel is priced on a one quarter lag, the CRU spot price with the discount applied off that. So, there’s lots of movement and uncertainty around commodities even now for next year.

Regarding price over the years, we’ve been good about capturing price against commodity headwinds. And as our standard practice, we’ll update you with specific comments in December at the analyst day.

And in terms of what we done on the cost side of the equation, we’ve reduced headcount at corporate and in the business units. We’ve moved some air handler production from our Marshalltown, Iowa facility to lower labor cost facility in South Carolina. South Carolina already had cheap metal capacity, so it made most sense to get it there more quickly for the savings.

And directly answering your question, we continue to queue up more projects as we see how markets develop ahead of the 2012 selling season. So, we continue to build scenarios and we’ll adjust our cost structure as needed.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. But it seems like if you were kind of net headwind this year of 15 million on price cost that you would at least catch that up in the 12th. Just based on additional price actions and then stabilization in commodities?

Todd Bluedorn

Short answer is if commodities stayed where we’re at today, that’s a true statement.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. Okay, great. And then, can you just comment on Kysor/Warren? It seems like if you pull that out, the profitability is still pretty anemic there. Is that meeting expectations? And I think you have given some guidance into ’12 on accretion. How is that lining up versus plans?

Todd Bluedorn

We’re executing against our synergy plan and feel very good about the acquisition. We expect solid margin improvement as we exit this year and still expect $0.12 of accretion in 2012.

Jeffrey Hammond – KeyBanc Capital Markets

Okay, great. And then, maybe just a couple of finer point questions. Where do you think inventories are at from your perspective and in your system? And if you can give us an ending share count for the quarter.

Todd Bluedorn

I let Bob get in on share account and make sure he has – do you know any share count?

Bob Hau

(inaudible)

Todd Bluedorn

Okay, I’ll answer the first one. This is for the rest on the call, Jeff, because you know this. We’re 80% one step where we sell directly to dealers and then 20% we sell through independent distribution. But independent distribution, I think for the 20%, we sell our Allied brands, it’s pretty lean. I think independent distributors have been cautious given all the macroeconomic uncertainty.

On our one step, we have minimal inventory with dealers. We think we stock the shelves. We just need some cold weather to set in to help drive furnace sales. But, when the weather changes and the market picks up, the inventory will flow very quickly through our channel.

Jeffrey Hammond – KeyBanc Capital Markets

Okay.

Bob Hau

And Jeff, we closed our third quarter about 51.6 million shares end the period. And as I mentioned in the script, full year, fully diluted will be at 53.5.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. Thanks guys.

Todd Bluedorn

Thanks, Jeff.

Operator

Thank you. We’ll go the line of Josh Pokrzywinski with MKM Partners. Please go ahead.

Josh Pokrzywinski – MKM Partners

Hi. Good morning guys.

Todd Bluedorn

Hi, Josh.

Bob Hau

Hi, Josh.

Josh Pokrzywinski – MKM Partners

Just looking for an update. The last quarter, you gave some helpful commentary on kind of the incoming order rate, not the numbers specifically, but kind of the bio language on commercial orders and where backlog was. If we could get an update, that would be helpful.

Todd Bluedorn

Commercial and refrigeration had a strong Q3 as you saw the numbers. But we’ve seen a bit of a slowdown on orders as you’d expect given the macroeconomic environment and uncertainty. Europe and mainly in the U.S., Europe has been resilient and while we continue to watch for any softening, we haven’t seen it yet. The slower orders in commercial and refrigeration are in part while we lowered our revenue guidance range for the year.

Josh Pokrzywinski

Got you. And if we could shift over to the furnace expectations, I know the new product line, I guess, the fuller line this year was kind of a source of early optimism heading in the fourth quarter. I would imagine you’ve seen some dealer loading there at this point. Any kind of first update or first view on how that has trended versus early expectations? Or is it just too soon to tell?

Todd Bluedorn

I think that’s what you said. It’s too early to tell. I mean, only in the last week or so, as the weather started to turn cold in many parts of the country, as the weather continues to turn cold, we’ll have a better read of the furnace sell-through, because you’re right, I mean, dealers have bought it and I think our dealers are excited by it. But we’ll have to see how it sells through to really get a read on what it means for Q4.

Josh Pokrzywinski – MKM Partners

Okay. And then, just one final one on R-22. Obviously, one of your competitors, similarly-sized competitors was out of that market this year and was looking to get back in next year. Any way calibrate how far above kind of normal share levels you’ve been on the low end, I guess, the 13 is your product that might be at risk next year should share kind of normalize with another competitor stepping in?

Todd Bluedorn

I don’t think we would be the ones who would lose share as train gets more aggressive on R-22. My guess is there’s others on the entry level who had more of a share gain at that position than we have. And R-22 play has been more with our Allied brands than with our Lennox brands. And so, I think that’s a segment of the market we’ll continue to compete and then do well.

Josh Pokrzywinski – MKM Partners

All right. Understood. Thanks guys.

Todd Bluedorn

Thanks, Josh.

Operator

Thank you. And we’ll go to the line of Robert Barry with UBS. Please go ahead.

Robert Barry – UBS

Hey, guys, good morning.

Todd Bludorn

Hey, Robert.

Bob Hau

Good morning, Robert.

Robert Barry – UBS

Did you mention that price was a benefit of 1% in (inaudible)?

Todd Bluedorn

Just check our notes and make sure what we said. Short answer is yes. That’s what we said.

Robert Barry – UBS

(inaudible) first a couple of quarters that had been backing higher than that? So, I was curious what happened there.

Todd Bluedorn

I think it was the timing of the price increases in terms of when we announced and what we’re seeing and how slow for P&L.

Robert Barry – UBS

(inaudible) price increase would be less impactful.

Todd Bluedorn

No. I mean, I don’t think I have any color to show. The pressure on pricing really hasn’t changed quarter-to-quarter and just sort of the timing of when we sell to builders, when we sell to contractors, the size of the dealer that we’re selling to. So, net-net, I think we’re comfortable where pricing was for the quarter.

Robert Barry – UBS

Okay. On commercial, it was like you had a pretty significant (inaudible). Could you just explain what is (inaudible)?

Todd Bluedorn

You’re breaking up on me, Robert. And so, I’ll attempt to answer the question and maybe get on another phone and call back. And I think the question was, “Why are we seeing such good price and price mix in commercial?” And I think it reflects a couple of things. It reflects the success that we’re seeing in our premium products, Energence and Strategos.

It also has to do with the mix of national accounts that we have in any given quarter. And it reflects the pricing actions that we’ve taken earlier in the year. So, where in resi, we have pricing increases at the end of last year and our commercial business, we had some pretty significant price increases partway through first quarter and we at the time said in first quarter and second quarter that we start to see that price flow through second half of the year and we’re in fact seeing that.

Operator

And we’ll go to the line of Adam Samuelson with Goldman Sachs, please go ahead.

Adam Samuelson – Goldman Sachs

Hi. Yes, good morning.

Todd Bluedorn

Hi, Adam.

Adam Samuelson – Goldman Sachs

I wanted to ask on Kysor/Warren. The required revenue is a little bit higher than we had modeled. What was the underlying organic growth in that business in the quarter? I think you’ve seen Hoffman [ph] struggle as they’ve worked through the divestiture there and just wondering kind of how you look at share on the refrigeration side?

Bob Hau

Yes, I don’t have the third quarter numbers for last year. That was back when I managed to walk on to – clearly, we’re seeing some good adjustments from their new product line and we continue to see future potential growth as they expand that into their full product spectrum.

Adam Samuelson – Goldman Sachs

Okay. Okay. And then, in the commercial business, I think you talked about slowing it in US orders. I know it’s early for 2012 but you’ve seen some larger customers including Wal-Mart say their US CapEx is going to be down next year. How do you think about the environment for 2012 even at least at the high level?

Todd Bluedorn

I think it’s what I said earlier. There’s lots of moving pieces both in res and commercial and we’ll give guidance in December of what we’re saying. I think we’re doing the right things in terms of taking cost out for any scenario. We think we have the right product for winning accounts. We think we’re winning in the market place in commercial and refrigeration.

As you well know, the Christmas selling season has a huge impact on our retail customers. And so, I think there are still some variables still to be played out for us to really have a clear view on 12 markets.

Adam Samuelson – Goldman Sachs

Okay, that’s fair. And then just finally for me, the cut for CapEx for the year, what was the driver and so far maybe some of the longer-term programs that you’ve been investing in kind of maybe where was that cut coming from?

Todd Bluedorn

I think it’s more just the timing of implementation. It wasn’t an explicit cut to generate cash. It’s just sort of the timing of implementation of projects.

Adam Samuelson – Goldman Sachs

Okay. All right. Thanks very much.

Todd Bluedorn

Thanks.

Operator

I think we’ll go to line of Rich Kwas with Wells Fargo Securities. Please go ahead.

Rich Kwas – Wells Fargo Securities

Hi, guys. Good morning.

Todd Bluedorn

Hi, Rich. How are you?

Rich Kwas – Wells Fargo Securities

Fine. As we think about 2012 just from a mixed standpoint on the resi side, R-22 at 20% this quarter flat with Q2, do you think that’s the high watermark? Given the competitive landscape right now, do you think that mix goes up meaningfully from here?

Todd Bluedorn

I would expect year-over-year comparison on the mix side to be less difficult in 2012 than what we saw in 2011. We’re approaching R-22. That’s going to be here for some time and we’re taking actions to compete there.

As you said, it was about 20% of our revenue. Again, it’s early. I think it’s probably going to be greater next year than it was this year, but not to step up that we saw from ’10 to ’11. So I’m not sure where the high watermark, but it’s going to be crusting soon if I have to bet now.

Rich Kwas – Wells Fargo Securities

Any sense that the economy getting better that kind of holds that growth? What’s the biggest trigger in terms of the mix on that front that you’re doing?

Todd Bluedorn

I think the biggest trigger, medium-term, it will be as you suggest the economy. It’s hard to imagine that in 2012 there will be a meaningful move in the economy to sort of change the dynamic we’ve seen. But I think it’s the economy changing. I think the closer we get to the efficiency changes in units, which is 2014, that that will help alleviate R-22 also.

Rich Kwas – Wells Fargo Securities

Okay. And then on the commodity front, I think last quarter you talked about some price increases from overseas suppliers affecting your increase in the commodity headwind from last quarter. Where are you with that? Is that fully implemented and do you expect to see any more headwind on that front as you move out over the next few quarters?

Todd Bluedorn

For 2011, we sort of reiterated the guidance we gave in terms of the headwinds of commodities of $60 million to $65 million and then pricing at 50 and the material cost reduction at 25. And then the only guidance we’ve given so far on ’12 is what I said in the script that we’re gaining confidence in the engineering-led cost reduction programs and we’re confident that in 2012 we can get similar order of magnitude material cost reduction savings that we have had over the last few years. But again, I’ll state the obvious, commodity cost, they were out and continue to go down. That gives us obviously leverage over our supply base, and we’ll take advantage of it.

Rich Kwas – Wells Fargo Securities

Okay. All right. Thank you.

Todd Bluedorn

Thanks.

Operator

And we’ll go to the line of Keith Hughes with SunTrust. Please go ahead.

Keith Hughes – SunTrust Robinson Humphrey

Thank you. Give us some sort of feel on the margin difference between the dry shift units and a traditional 13 SEER with 410A versus the higher? Just any kind of number is really helpful.

Todd Bluedorn

The margin percentage isn’t so much different on a 13 SEER R-22 and a 13 SEER 410A. I think the big difference is the dollar value is lower. And then when you sell 410A, you often bring the air coil and the furnace with it.

So, I think it’s both an unbundling of the system sell as well as the way the pricing of the R-22 unit has been positioned in the market by the low-end competitors. It’s sold at a dollar discount versus a 410A.

Keith Hughes – SunTrust Robinson Humphrey

So, are you getting substantial less margin just selling the R-22 universe, the furnace and the other components?

Todd Bluedorn

If I understood the question, we miss out on – we sell our R-22 units. It sells for about...

Bob Hau

About $1,800.

Todd Bluedorn

About $1,500, $1,800. Where if we sell 1410A system, it’s $5,000, $6,000 when we put the whole system in. Condensing unit to condensing unit, R-22 is a lower price than what the 410A is.

Keith Hughes – SunTrust Robinson Humphrey

Because your revenue numbers in residential are not all that bad, but I would expect that the math you just gave me to be much worse because it is the margin is where you’re getting it. That’s where I’m confused.

Todd Bluedorn

Yes, it’s the margin where we’re getting it.

Keith Hughes – SunTrust Robinson Humphrey

So, why are you getting hit so much more on the margin? It seems like we would see more hit on the revenue line.

Todd Bluedorn

The reason we’re getting hit on the margin is our furnaces (inaudible). We on a year-over-year basis are down significantly in margin mix because a year ago, it’s not only that we not have R-22 but we also had the $1,500 tax credit. And so, it’s a combination of the two.

And so, a year ago, we were able to replace the 410A system, used $1,500 tax credit to sell off to our most premium furnace in an essence, say, you can get a furnace, premium furnace for half price. This year, we’re not getting the tag-along furnace and we’re certainly not getting as many premium furnaces. So, it’s a mix down on our furnace lines as well as a margin down on our R-22 conducting units.

Keith Hughes – SunTrust Robinson Humphrey

Okay. So, going in to ’12, boring any changes to the economy and things to that nature, the mix as you read off between 14 SEER and above and dry shift, those are bases we’re going to stay about the same and maybe few points need a direction. But there’s nothing else out there that’s going to cause that to move down, correct?

Todd Bluedorn

I don’t think there are the structural changes that we saw from ’10 to ’11, at least not that we can see now, the $1,500 tax credit R-22. I think the changes will sort of be the incremental changes.

There’s a $500 tax credit that goes away next year. We don’t think that will have the same impact as the 1,500 gone from 1,500 to 500. There’s the point that was made earlier that the fact that at least one large competitor who didn’t play this year in R-22, we’ll sort of focus on it. But I don’t think there’s the big structural changes or systematic shocks that we saw this year.

Keith Hughes – SunTrust Robinson Humphrey

Okay. Thank you.

Todd Bluedorn

Okay.

Operator

Thank you. (Operator instructions) And we’ll go to the line of Steve Tusa with JP Morgan. Please go ahead.

Steve Tusa – JP Morgan

Hi, good morning.

Todd Bluedorn

Hey, Steve.

Bob Hau

Hi, Steve.

Steve Cuso – JP Morgan

Just to follow on to the question about that competitor. I’m just curious to the mechanics of how one kind of re-enters or gets into the R-22 market. From your perspective, how easy is it to kind of flip the switch?

I mean, is it a function of educating and putting right the incentive in place for the dealers? How hard is that to do? Because I presume you guys earlier in the year weren’t planning on being the big player on R-22, but you’ve clearly taken or at least stem some of the share that your light competitor did.

So, I’m just curious as to strategically how easy that is.

Todd Bluedorn

I don’t want to play trains hand for them, but I think the way we thought about it what’s better stated.

I think that you have to have the right channel to sell it or it helps to have the right channel to sell it. And so, premium dealers, high-end dealers aren’t trained or aren’t sort of skewed that direction you spent years, decades training them system sell, premium sell.

That’s how we levered our Allied distribution network to do it. And so, like I said earlier, we’re 20% overall but in Allied it’s a much higher percentage. And so, we levered the distribution channel that’s focused on entry level product. I don’t know how much of that train has and whether they’re going to be able to make the switch. But my guess is they’ll find a way to sell R-22 into the market.

Steve Tusa – JP Morgan

Right. So your Allied brand, how much was Allied up in the quarter?

Todd Bluedorn

Allied was up – what we’ve talked about was up double digits in condensing units and down low single digits overall in furnaces and that was both brands together.

Steve Tusa – JP Morgan

What does this R-22 result this year kind of tell you guys about the value proposition that the industry continue to try and push towards higher SEER products? I assume you need to have a good feed through service experts, so you must have a good re-entry into the consumer behavior around compressor repairs in R-22.

I mean, how worried are you guys about the dynamic that this is just forever kind of a value industry? And there may be some structural headwind even on the pent-up side as you push SEERS and equipment prices higher, system prices higher.

Todd Bluedorn

I don’t think it’s changed forever. I mean forever is a long time. For 30 years, this has been an industry where we’ve had multiple tiers and you’ve been able to differentiate around consumer requirements. Whether it’s historically been efficiency where it’s increasingly becoming controls and the quality of comfort that’s produced, I don’t think that’s changed.

There’s lots of businesses where you continue to differentiate. I think what it’s thought us, I think it’s thought a lot of people that when you’re in the third or fourth year of a stark economic turndown and the consumer is as fragile as they are now, they’ll look to avoid spending money.

But we’re still able to differentiate on the premium side, we’re still able to get money for premium product, and as the economy starts to heal, I think that we’ll even see more of that happening. So I don’t think the business is broken. I think it’s shifted down given the economic environment.

But it’s incumbent upon us to innovate and differentiate so consumers want to spend the incremental money, because it will either save their operating costs or allow them to have a cooling experience that they like, and we think we can get paid for that.

Steve Tusa – JP Morgan

Right. And clearly stuff is still breaking obviously. So it’s not as if there’s not this pool of aging units out there, it seems like, given that R-22 has jumped so much this year.

Todd Bluedorn

Right. Now there’s still pent-up demand being created and there’s still a bio wave coming, and when that bio wave comes, we think we’re going to be in a position, because the climate would have turned that we’re going to mix up like we always have. And it’s not like the industry has.

Steve Tusa – JP Morgan

Right. And then any to calibrate expectations for the fourth quarter? It was a good quarter with the end of tax credit for some and anything you want to just let us know about how you see the fourth quarter right now, incremental weakness anywhere, any (inaudible) around the fourth quarter?

Todd Bluedorn

I mean it’s really too early to tell just on the stance. I mean we lowered our revenue guidance for the full year. That reflects, as I said earlier, some of the weak order rates we saw on commercial and refrigeration. On the resi side, we have to have the weather turn cold and see the sell-through. I mean we’ve done a good job sort of positioning independent distributors and then our dealers, and we just have to see how the weather shakes out.

But again, as we all know, our resi business is a two-week lead time and up to 40% of the volumes in the month of December. So we still have a lot in front of us.

Steve Tusa – JP Morgan

Sure. Okay. Thanks a lot.

Todd Bluedorn

Good. Thanks, Steve.

Operator

Thank you. And I’ll turn it back to Todd.

Todd Bluedorn

Okay. Thanks, everyone. I want to leave you with a couple of key points. Our commercial and refrigeration businesses have been sold, with good shipment growth and favorable price and mix. Residential has seen good shipment growth and favorable price, but mix continues to be down compared to a year ago.

In response, the company has taken aggressive cost reduction measures and continues to engage in new productivity and growth initiatives for 2011 and 2012. The final point is that we will continue to use our strong balance sheet to grow the business as well as return cash to shareholders through a competitive dividend and share repurchases, including a target of $120 million in 2011.

Thank you for joining us today.

Operator

Thank you ladies and gentlemen. That does conclude your conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.

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