Earnings Call: Q3 2018

Oct 22, 2018

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Third Quarter 2018 Earnings Conference Call. At the request of your host, all lines are in a listen only mode. There will be a question and answer session at the end of the presentation. As a reminder, this call is being recorded. I would now like to turn the conference over to Steve Harrison, Vice President of Investor Relations. Please go ahead. Good morning. Thank you for joining us for this review of Lennox International's financial performance for the Q3 of 2018. I'm here today with Chairman and CEO, Todd Pfludorn and CFO, Joe Reitmeier. Todd will review key points for the quarter. Joe will take you through the company's financial performance and outlook. To give everyone time to ask questions during the Q and A, please limit yourself to a couple of questions or follow ups and re queue for any additional questions. In the earnings release we issued this morning, we have included the necessary reconciliation of the non GAAP financial measures that will be discussed to GAAP measures. All comparisons mentioned today are against the prior year period unless otherwise noted. You can find a direct link to the webcast of today's conference call on our website at www.lennoxonnational.com. The webcast also will be archived on the site for replay. I'd like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Lennox International's publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward looking statements, whether as a result of new information, future events or otherwise. Before I turn the call over to Todd, I would like to announce the date of our Annual Investment Community Meeting. The event will be held the morning of Wednesday, December 12, in New York City. Please mark your calendars, invitations and more details will follow. The meeting will also be webcast. Now let me turn the call over to Chairman and CEO, Todd Bluedorn. Thanks, Steve. Good morning, everyone, and thank you for joining us. There are a lot of moving pieces and noise from the tornado impact on the reported results to walk through for the Q3 and as we look ahead. First, let me level set everyone with our estimates on the impact from the tornado that damaged our Marshalltown, Iowa residential manufacturing facility on July 19 And also make the overarching comment to keep in mind that the lost profits in 2018 2019 from business interruption due to the tornado will be fully offset by insurance proceeds in 2019 and be a benefit to us in that year. On our last conference call 1 month after the tornado hit, we estimated the impact on our core business for 2018 of approximately $100,000,000 of revenue $55,000,000 of segment profit and about $1.05 of EPS. Our initial view is that about onethree of this impact would hit in the 3rd quarter and about twothree would hit the 4th quarter. Further along, with more visibility, our current view is that the impact to our core business in 2018 will be approximately $115,000,000 of revenue, dollars 65,000,000 of segment profit and $1.25 of EPS. We now expect approximately 40% of this impact was in the 3rd quarter and 60% will be in the 4th quarter. So in the 3rd quarter, we had $0.52 of tornado impact on our core business, which was 0.17 dollars approximately $0.17 more than originally estimated. From an operational viewpoint, the recovery is at or ahead of schedule in all key areas. The Lennox team and our partners in the recovery have done a tremendous job, and the Marshalltown community in Iowa have provided strong support. We still have a ways to go, but we expect to come out of this even better position than before. The change in the 2018 financial estimates come from a clear view on customer dynamics in the near term relative to our original round number estimates. For example, with the Lennox high efficiency equipment shortages, we are seeing a lower number of visits to our Parts Plus stores during this time and lower sales of accessories, parts and supplies. We have maintained close relationships and strong lines of communications with our dealers, And we remain confident that we will win the short term borrowed market share back given the many reasons these customers were doing the majority of their business with us in the first place. Looking ahead to 2019, we are introducing a view on the tornado impact on our core business for next year. We're estimating approximately $85,000,000 of impact to revenue and $35,000,000 to segment profit and $0.70 to EPS. To reiterate, the lost profits in 2019 are fully covered by insurance, and we expect to receive the proceeds in the same year. Below the line for 2018, noncore special pretax charges related to the tornado are still expected to be approximately $80,000,000 offset by insurance proceeds in 2018. In the Q3, we had $49,000,000 of these charges, offset by $49,000,000 of insurance recovery. Below the line for 2019, we're estimating non core special pretax charges relating to the tornado impact of US15 $1,000,000 We expect these to be more than offset by insurance proceeds in line with the cost to replace. Turning to the business results as reported today. For the company overall, revenue on a GAAP basis was $1,030,000,000 down 2%. On an adjusted basis, excluding non core refrigeration business in Australia, Asia and South America divested in 2018, revenue was up 2% to a 3rd quarter record $1,020,000,000 Foreign exchange was neutral to revenue. On a GAAP basis, operating income was $145,000,000 in the 3rd quarter, down 6%. GAAP EPS from continuing operations was a 3rd quarter record, dollars 2.65 up 8%. On an adjusted basis, total segment profit declined 3% to $155,000,000 Total segment margin was down 80 basis points to 15.2%. Adjusted EPS from continuing operations rose 8% to a 3rd quarter record of $2.72 dollars Turning to the key points on our business segment for the 3rd quarter. Our residential and commercial businesses set new record highs for revenue, and refrigeration set a new all time high for segment margin. In residential, of course, impacted by the tornado, revenue rose 1%, profit was down 1% and segment margin was down 40 basis points to 19%. Residential revenue from our price point business was up low single digits and new construction was down low single digits. Turning to Commercial. Revenue was up 2%, segment profit was down 7% and margin was down 170 basis points 16.9%. Commercial's performance was impacted by the lumpiness of shipments in our commercial national accounts equipment business, lower factory productivity and the timing of about $2,000,000 of expenses on a year over year basis. Breaking down commercial revenue for the 3rd quarter. National account equipment revenue was down low single digits compared to 20% growth in the prior year quarter. Year to date, national accounts revenue is up low single digits, which includes being up low double digits in the second quarter and flat in Q1, as is typical, not straight line growth here. As we look at the 1st 3 weeks of October, the backlog is strong, up double digits, and we are tracking having strong growth in the 4th quarter. For our local and regional commercial businesses in the 3rd quarter, revenue was up Overall for North America Equipment, revenue was up low single digits at constant currency. Replacement revenue was up high single digits and new construction was down high single digits at constant currency. On the commercial service side, Lennox account services revenue was up high teens. In Europe, commercial HVAC revenue was down low double digits as market softness continues. Turning to our core refrigeration business. Revenue was up 4%. In North America, constant currency revenue was up mid single digits. And Europe at constant currency revenue was also up mid single digits, led by double digit growth in our non food business. Refrigeration profit rose 19% in the 3rd quarter and segment margin expanded 190 basis points to 15.4%. We completed the last of the divestitures planned for this year, closing on the sale of our South America business in the 3rd quarter. In the Q2, we closed on the sale of our Asia and Australia businesses as well as the sale of real estate in the Sydney area. Total net proceeds from these transactions were $116,000,000 Overall for the company, price cost was favorable in the 3rd quarter. We had $27,000,000 of price benefit, more than 2.5 percent of revenue, which more than offset commodity, freight and tariff headwinds in the quarter. We have even more confidence on price for 2018 and are raising our guidance for price benefit from $75,000,000 to $80,000,000 for the year. We plan to repurchase $100,000,000 of stock in Q4 for a total of $450,000,000 this year as we look forward to a strong close to 2018 and ahead to 2019. We remain focused on normalizing residential production and continuing to execute on our corporate initiatives to drive company performance and shareholder value. Now let me turn it over to Joe to talk more in detail about Q3 performance and the full year outlook. Thank you, Todd, and good morning, everyone. I'll provide some additional comments and financial details on the business segments for the quarter, starting with Residential Heating and Cooling. In the Q3, revenue from Residential Heating and Cooling was a 3rd quarter record $595,000,000 up 1%. Volume was down 2%, price was up 3% and mix was relatively flat. Foreign exchange was neutral to revenue. Residential profit was $113,000,000 down 1%. Segment margin was down 40 basis points to 19%. Segment profit was impacted by the tornado and the business had lower volume, higher commodity freight, distribution and other product costs and other favorable foreign exchange in the quarter. Partial offsets included higher price, sourcing and engineering led cost reductions, factory productivity and lower SG and A expenses. Turning to our commercial heating and cooling business. Commercial revenue was a 3rd quarter record $276,000,000 up 2 percent. Volume was up 1%, price was up 1% and mix was flat. Foreign exchange was neutral to revenue. Commercial segment profit was $47,000,000 down 7%. Segment margin was 16.9%, down 170 basis points. Segment profit was impacted by higher commodity, freight, distribution and other product costs, higher SG and A expenses and unfavorable foreign exchange. Partial offsets include higher volume, favorable price and sourcing and engineering led cost reductions. In our Refrigeration segment, which excludes the non core businesses in Australia, Asia and South America that we divested this year. Revenue in the 3rd quarter was $153,000,000 up 4%. Volume was up 4%, price was up 2% and mix was down 2%. Foreign exchange was neutral to revenue. By region, on a reported basis at actual currency, North America and Europe were both up mid single digits. Refrigeration segment profit was $24,000,000 up 19%. Segment margin was 15.4%, up 190 basis points. Segment profit was impacted by higher volume, higher price, sourcing and engineering and lower SG and A expenses. Partial offsets include higher commodity and freight costs. Overall for the company, on an adjusted basis, the 3rd quarter had a net after tax charges of $2,400,000 This included $2,400,000 for the net loss on the sale of business and related property, a total of $3,100,000 for various other items and a $1,700,000 benefit for excess tax benefits from share based compensation and a $1,400,000 net benefit for other tax items. Corporate expenses were $28,000,000 in the 3rd quarter, up from $24,000,000 in the prior year quarter. Overall, SG and A on a GAAP basis was $149,000,000 in the 3rd quarter or 14.5 percent of revenue, down from 15.1% in the prior year quarter. On an adjusted basis, SG and A as a percent of revenue was 14.4% in the 3rd quarter, down from 14.5% in the prior year quarter. Net cash from operations in the 3rd quarter was $266,000,000 including $45,000,000 in cash from insurance proceeds compared to $177,000,000 in the 3rd quarter a year ago. Capital expenditures were $18,000,000 compared to $17,000,000 in the prior quarter and free cash flow was approximately $248,000,000 compared to $160,000,000 in the Q3 a year ago. Total debt was $1,130,000,000 at the end of the quarter and we ended September with a debt to EBITDA ratio of 1.9. Cash and cash equivalents were $46,000,000 at the end of September. The company paid $26,000,000 in dividends in the Q3. Before I turn it over to Q and A, I'll review our current outlook for 2018. Our underlying market assumptions for 2018 are unchanged. For the industry overall, we still expect North American Residential HVAC shipments to be up mid single digits. We expect North America commercial unitary shipments to be up low single digits, and we expect North America refrigeration shipments to be up low single digits. We are reiterating our 2018 guidance for GAAP revenue growth of 2% to 4% and for an adjusted revenue growth of 4% to 6%. We are updating our 2018 guidance for GAAP EPS from continuing operations from $8.38 to $8.78 to a new range of $8.11 to 8.51 dollars We are updating 2018 guidance for adjusted EPS from continuing operations from $8.90 to $9.30 to a new range of $8.70 to $9.10 The updated GAAP and adjusted EPS ranges include the additional $0.20 tornado impact expected this year, dollars 0.17 of which were in the Q3. This will be a benefit to 2019 upon receipt of insurance proceeds next year. Now let me walk you through the various puts and takes in our 2018 guidance, starting with the ones that are changing. As Todd mentioned, we are raising our guidance from price from $75,000,000 to $80,000,000 on even more confidence on capturing yield this year. And as we look ahead to 2019, our commercial business has already announced a price increase of up to 4% to be effective January 1. For commodities, we now expect $45,000,000 of headwind for the full year, down from our prior guidance of $50,000,000 Freight expenses are now expected to be $25,000,000 for this year, up from the prior guidance of $20,000,000 And we now expect $30,000,000 of savings from our sourcing and engineering led cost reduction programs, down from prior year guidance of $35,000,000 For the 2018 guidance points that remain the same, foreign exchange is expected to be neutral for the year, Tariffs are still a $5,000,000 headwind for 2018. We still see $7,000,000 of savings from our residential factories as we focus on automation at our U. S. Plants and other productivity initiatives. Our distribution investments are a $10,000,000 headwind. SG and A is still expected to be about $10,000,000 over last year, and the corporate expense target for this year remains approximately $85,000,000 Now just a few other guidance points. Net interest expense is expected to be a bit over $35,000,000 for the full year. Tax rate guidance remains 22% to 24 percent on an adjusted basis for the full year. Capital expenditures are still planned to be approximately $100,000,000 excluding the impact of the tornado repairs. We are planning a total of $450,000,000 stock repurchases for the full year and are reiterating guidance for an average diluted share count of approximately 41,000,000 shares on a full year basis. And we are still targeting approximately $395,000,000 of free cash flow for the full year. And with that, let's go to Q and A. Our first question is from the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead. Hey, good morning guys. Hey Jeff. Hey, just so on the impact, one, what's informing the higher amount for 2018? And then what does that the 85,000,000 what does that imply you'll be back to normal production by? And then just also it looks like you're using lower incremental margins or margins on the 'nineteen impact. If you could just kind of touch on why that is? Thanks. Let me see if I get all parts of the question. If not, jump back in and correct me. First on, I think first part of the question is why did we sort of raise the 'eighteen guide for the tornado impact? And I think I'd answer it a couple of ways. One is the first guide we gave was about 3 weeks after the tornado, and we did a high level estimate of round numbers. And I sort of made the point $100,000,000 was a big round number, dollars 100,000,000 of revenue and $55,000,000 of segment profit or $1.05 of EPX for 2018. We've refined those estimates now that we're several 2, 3 months into this thing, and we've gotten further along and have a clearer view, quite frankly, on the customer dynamics in the near term. And as I said on the call or on the script operation, we were ahead of or at where we thought we'd be on sort of building a product ramping up. It just reflects how customers are buying, specifically, as I mentioned in the on the script about the attachment rate of parts and supplies and accessories to when we sell major pieces of equipment. I think the other part of the question was just operationally where do we stand and where we're being ramped up. When we look at full production capability for Lennox Residential, and this includes all three residential factories, Marshalltown, Orangeburg and Satillo, And that's how I'll talk about it, sort of full production capability. In Marshalltown, the heating product section of the factory had the most damage and the cooling product section had relatively less damage. So for cooling products, we expect Lennox to be back up to full pre tornado production capability early in Q4 in 'eighteen, so here in the next month or so. For heating products, we expect Lennox to be back up to full production capability in Q1 of 2019. We will have a bit of lag from perspective of fully meeting market demand due to having to catch up on rebuilding our inventory in the channel. And so sort of the tornado impact, if you will, will sort of bleed into Q2 even though we're up to full production as we'll have to sort of ramp up to build even more inventory. And I think the other question is why was the drop through different in 'nineteen versus 'eighteen? This is a function of the mix of products and the product here is impacted. And really sort of shorthand, I'd point to furnaces are more profitable than air conditioners and we are more impacted by furnaces in 2018 than we will be in 2019. Okay, I think that's everything asked. Yes. You covered it. Great. And then just can you just talk about how you're thinking you mentioned the price increase in commercial, how you're thinking about price cost as you move into 2019? And then you lowered the material cost savings bucket for this year. How should we think about that bucket into 'nineteen? I'll get back in queue. We lowered the price or excuse me, the material cost reduction bucket, just reflecting sort of more inflation because again, this is always number. I also mentioned on the call that 3rd quarter yes, 3rd quarter, we turned the corner. Got quarter on corner mixed up. In Q3, we turned the corner and had $27,000,000 of price more than offset commodities, freight and tariffs, excuse me. And as we go into 2019, that's clearly going to be the case as we're setting up now unless commodities move on us very quickly. We have announced a commercial price increase. We thought it was, quite frankly, bad form to announce a residential price increase right now with all the moving pieces. But we're clearly going to announce a residential and refrigeration price increase as we go into 2019. I'll give more specific math at the December Analyst Day, but price, commodities, tariffs and freight will be a net positive to us in 2019. Thanks a lot. All right. Thanks, Jeff. Next, we go to the line of Steve Tusa with JPMorgan. Please go ahead. Hey, guys. How's it going? Thanks for all the detail on the unfortunate situation there. Just on the market, you guys were down in resi and in new housing related business. Can you maybe just discuss what you think kind of the markets have done this quarter? So just so we can kind of figure out where the impact for you guys is kind of most pertinent or maybe it's split between the 2, new housing versus replacement in resi? I think it's split between the 2. And I when we really started seeing a tornado impact in September. So the vast majority I don't want to say all, but the vast majority of the tornado impact was in September. In July August, we were off to a strong start in residential, both in new construction in and add on replacement. And to give a read through to the other guys, I think the market was pretty strong in Q3. August July August, we're up mid to high single digits in residential, both segments of the marketplace. And then obviously, we saw as we ran out started to run out of equipment, we saw the impact in September. And I think the weather was reasonably good in September. So I think overall, the market was probably strong for the quarter. Got it. And then with regards to tariffs, what are you this new round that's come out or at least the new couple of rounds, I can't even keep track anymore, but how are you kind of thinking about that specifically for now for 2019? And how much of that impact, I don't know if you gave it yet, but what is the specific impact that you think from that on 2018? For 2018, we think the overall impact is $5,000,000 and that's the guide. And again, that's included what's been implemented, what's been announced with detail, but doesn't include any tweets that sort of even add more to it than that. So it's sort of it's what you can do the math on. We think that 20 18 order of magnitude is going to be $5,000,000 And then I publicly said, that's in essence sort of less than half a year. And so 2019 is going to be something probably a little over twice that. And then the other point I'd like to make is we're proactively taking action. I'm not sure that Chinese tariffs are going to be short term, and so we're taking action to sort of avoid the tariffs by moving to Southeast Asia and other low cost countries that can meet our requirements. And that's the gross number that just basically taking what you buy and kind of marking it up by the amount of the tariffs? Or is that kind of the net number? It's sort of our it's the net number. So the $5,000,000 is what order of magnitude $5,000,000 is what we expect to see on the P and L. Okay. We haven't guided yet on 'nineteen, but I would sort of take over twice that amount and sort of advise building a model and assume that for 'nineteen. Okay. And then again, just to be clear on this because a lot of everybody is kind of approaching their communications around this in different ways. That would reflect the new round of stuff that's coming through at kind of a higher rate, correct? So that's the that would reflect the incremental okay, got it. All right. And then just one more. You talked about doing something in resi, but obviously not exactly the right time to go through with something additional. There have been others that have gone through with other price increases. Is your sense that if you did go out with something in resi here in the near term, excluding the tornado impact that customers have yet to kind of push back on that price or everybody is generally understanding of the, I. E, price discipline in the industry and the acceptance of that price is still pretty strong in the channel? I think I'll unpack it a couple of ways. To that question, I'd say, which is a direct question, customers expect price increases and some of several of our competitors have announced some things we announced in commercial mix. They're not surprised they're accepting it, 0.1. 0.2 is we raised our price guide in 2018 from $75,000,000 to $80,000,000 And that $5,000,000 is I think I'm comfortable saying it's exclusively residential. So quite frankly, we didn't have to announce a price increase. It's always about the yield and how you hang on to it. And so we're getting better price yield in residential, just like we speculated we might, given the shortage of inventory. But we didn't want to announce something new. We're just sort of continuing to toe the line and getting a better yield than what we thought we were. And then as we go into 'nineteen, we're confident again that we'll announce another price increase and get more price in 2019, both in res and in our other businesses. Okay. Sorry. One more quick one. Sorry to dominate the early innings here. You made some comments at a recent conference, competitor conference that you kind of opined on consolidation in the industry and you said that you believe that there could be consolidation among the top 4 resi guys out there despite what looks like a reasonably consolidated situation. Can you maybe just clarify that or maybe I read that in the transcript the wrong way? Can you maybe clarify what you said there on industry consolidation of potentially one of the top 4 resi guys? I was asked a question. I think you got it, what I said pretty close. I always get in trouble when I opine. So maybe strike the opine. I asked the question to answer the question. But I don't know York's residential market share, but I think it has one digit in it. And so I think they could combine with other players in the industry, certainly could combine with us. I think the commercial unitary share starts with 1 digit. And then their applied is a larger part of the business. But they so the New York business can certainly combine with us. And when I look at the other residential businesses, it's other players, again, I think they could combine with York or maybe even us. So I think those were the that was sort of the broad question of that I think anything was prohibit. Are there things that couldn't happen? Certainly. But are there combinations that could happen? Certainly. Right. I guess you commented on York very specifically. Can you comment on Carrier very specifically? I'm not their share starts with 2 digits, I know that. And then beyond that, I'm not exactly sure where they're at. So my guess is they could combine with us. I think they could well, certainly, they could combine with York and I think they could combine with us, but I don't know that for certain. And it also depends what's being enforced at the time, but I think it'd be I don't know the exact number because I don't know carrier share. Okay. I'll leave it at that. Thanks a lot. Next, we go to the line of Jeffrey Sprague with Vertical Research Partners. Please go ahead. Well, I can't help but to pick up on that. It's a good way. You guys are feeding frenzy on this I know. Well, he's not talking about tornadoes, right? I know for a fact Greg knows the carrier share, so you should ask him. We think you know it too, but we won't question. Does consolidation make sense? What would be gained in your view given kind of this great pricing discipline that we're observing, especially in the resi business. Well, I mean, industry consolidation, obviously, with the caveat of it, the right price. But I think it'd be traditional horizontal integration of an industry. So and I would view it as distribution forward. So consolidating factories, consolidating supplier spend, taking out SG and A, taking out corporate expenses. We're making significant investments, we as a company, in digitization of the business, significant investments in control systems. Again, that could all be leveraged over a larger volume business. We have a great Mexico campus. Most of our competitors on residential don't. And so the ability to leverage that Mexican campus to lower costs. So I just sort of think traditional cost takeouts in an assembled product business like we have, I think you could create lots of synergies. And then again, it'd have to be at the right price. But I think it's clear industrial logic of how we take out costs. And how about on the distribution side, Todd? Some companies have chosen to kind of third party their distributions, others like you own it, putting that type of footprint together? Do you see any particular challenges there? My experience haven't seen this done at other places I've been at is I think the challenge is to make sure you don't lose market share when you rip all the costs out of the back end. And so my perspective on it would be in an industry like this, when you consolidate, that there would be some period of time you leave distribution alone. And so whatever it was, you'd optimize it and manage it as it was. I don't think you'd want to sort of go from one model to another company owned distribution, a JV or independent distribution, company owned distribution, a JV or independent distribution, you could leverage those investments with those distributors. So I don't think you have to physically make a change in distribution to leverage some of the investments that the company was making. And then just one on the quarter for me. Just to kind of make sure I've got my head around really what's going on in your margins, right? So the resi margins we're seeing today, obviously, you have a revenue impact on the top line, but you have little or no overt profit impact on insurance recoveries, right? So we can kind of calculate an underlying insurance recoveries, right? So we can kind of calculate an underlying margin that's lower than your headline margin. Is that difference primarily this negative, I'll call it, ripple effect for lack of a better term in the Parts Plus and other parts of your business? Or how would you characterize that? I'm not sure I understand the question. You had me right to the end when you started talking about Parts Plus. Well, I'm just saying your underlying margins arguably were down, right? And I'm just trying to understand the composition of that in resi. I'll ramble and see if I answer the questions. I mean margins were down because of the tornado impact on revenue and the corresponding impact on EBIT is why they were down. And even from the guide that we've given earlier, which was $125,000,000 of EBIT, a third of it in 4th quarter, we're now saying it's 40% in 3rd quarter and the overall number is going up to $65,000,000 of EBIT and $120,000,000 of revenue. And we performed extremely well in residential. And so if I understand the question right, it's all because of the tornado. Okay, got it. Thank you. Thanks. Next, we go to the line of Julian Mitchell with Barclays. Please go ahead. Thanks a lot. So maybe just trying to stick to 2 questions. The first one on the commercial business, if there was any color you could give on U. S. Trends as they stand today? And also on the margin front, margins were down a bunch in the Q3. How quickly do you think that comes back? And any extra detail you can give on the factory productivity you cited? First talking about commercial, and I talked about it in the call, I think, in some detail. It's just the lumpiness in national accounts. And so we feel confident in Q4, still a lot of work in front of us, but through the 1st 3 weeks of our quarter, backlog is strong, up double digits, And we're tracking to have another strong revenue quarter for commercial in 4th quarter. And so second quarter Q1, we were flattish in commercial. 2nd quarter, we were up 18%. 3rd quarter, we were flattish. In 4th quarter, we're going to have strong revenue growth. In terms of the margin, as I mentioned in the call, it was impacted by a couple of things. One was the timing of some expenses, just sort of the year over year differences of when you make adjustments for expenses like warranty and LIFO without getting too accounting on you. And then the other one, I think more operational was we had factory productivity issues in Q3. And really what's driving factory productivity issues is we're seeing labor shortages in our Stuttgart facility, and we've been addressing it with over time and extra shifts to be able to meet customer demands. And we're in the process of staffing up with full time workers. We've historically used quite a bit of temporary workers. Now we're moving to full time workers and converting the temp workers to full time workers. And this will have the issue around labor productivity and not having enough folks will have impact in Q3 and we'll also see a bleed off into Q4. So when on the Q4 call, I'll also be talking about this because it just takes a while to get it in place. But we expect to have it fully resolved by Q1 2019. Thank you for the detail. My second question would be on Refrigeration. One of your peers had talked about the retail maybe just any commentary on how you see the market in U. S. Retail Refrigeration? I still think it's tough. I mean, Dover refers to it as retail refrigeration. We refer to it as grocery. I assume that's what you're talking about. And that has the biggest impact in our Kaiser and Warren segment. We still saw revenue down in KW even though we were up in North America. Where we're seeing the growth in our North America business is driven the year over year growth is in large part driven cold storage. And so it's not the retail segment or the grocery segment, it's sort of other parts of the cold storage channel, colds chain and cold storage market where we've seen the growth. Next is the line of Gautam Khanna with Cowen. Please go ahead. Thanks. Good morning. Hey, Hey, Tom. How are you? Doing well. I was wondering, Todd, could you just talk a little bit about your confidence level in re capturing the share that you're sort of giving up in the interim while you're recovering from the tornado. What specifically can you do to kind of what gives you that confidence? And what are you doing to make sure on the other side of it, we're not going to see an impact at Parts Plus or elsewhere? Yes. I mean, we're working hard to do that. And I mean, as I've spoken about before, and you've heard me say, Con, and I'll say it for everybody else is we're communicating very clearly with our dealer partners. We're out there daily talking to them about what we have and when we're going to have it back and allowing them to make the transition. I've used the phrase a week early rather than a week late. So we don't want to run out of equipment and then have them be feel the pain. So we want we'll feel the pain and allow them to move over. I think that honest open communication helps a lot. And then the second thing is going to be on the flip side that as we reach full production capability and as I spoke about, we expect air conditioners in 4th quarter and furnaces in Q1 will be up full production capability. That as we start to make new commitments to people and turn them back on, that we execute against those new commitments. So we don't let them down on the way down and then we don't let them down on the way back up, and we're very focused on doing that. Overall, we have a loyal Lennox dealer base. And as I've mentioned also on prior calls, almost all dealers carry multiple brands. And we think the majority of this borrowed share will be someone who did business with us and with competitor B and they'll move some volume to competitor B while we're not able to provide supply. And then when we come back online, they'll move the share back to us. And so we're very focused on this, and we'll put incentives in place for our sales guys and sort of do all the right things to make sure we have laser like focus in 'nineteen, but we're committed to doing that. Okay. And just a quick follow-up on just the national account equipment and service pipeline as you look out to 2019. Can you make any comments on how rich an environment it is? 2019, a little early to sort of speculate or even give guide because the order book tends to fill up 3, 4, 5 months ahead of itself. So 'nineteen is still very early. And then the other caveat I'd make is we always know much more about national accounts once we get through the Christmas selling season that retail, while we reduced our exposure to that, still about half of our national account business. And so getting a better take on the Christmas selling season will help us. All that being said, retail is strong right now. Consumers are spending money. Consumers feel good. Retailers are spending money on things they weren't a year or 2 ago in our industry. So we feel pretty good as we go into 2019, but we'll give more of a guide at December Analyst Day. Thank you. Thanks. Next, we go to the line of John Walsh with Credit Suisse. Please go ahead. Hi, good morning. Hi, good morning. So I apologize if I missed it, but as we think about the moving parts for the free cash flow, can you help us think about maybe a finer point on this year and then next year as you're looking to rebuild inventory and how that kind of impacts the conversion ratio? I don't think we've gone into that kind of detail quite yet about sort of how it's going to impact. I mean, I would point out we had a very strong quarter in cash generation in Q3, and so we continued to generate cash. But we sort of haven't put a fine tooth answer about the inventory bleed out and inventory rebuild. The only point we made on cash is that the below the line impact of $80,000,000 I'm looking to make sure I have that number right. But we'll expect to have an amount of cash proceeds to offset that. So we'll be neutral on cash on the below the line charges, you will. And then Q3, we saw that $47,000,000 $47 on the offsets. And then for the above the line impact, sort of the core impact, we expect to have cash proceeds in 2019 to offset the EBIT miss or the EBIT that will shift or that we're not going to get in 2018 because of the lost revenue. We'll get that back in EBIT payoff from the earn payoff from the insurance companies and cash in 2019. Yes. And we're compensating with the lost profits, which are proxy for cash flow. We're going to obviously offset that or compensate with lower investments in working capital and inventory, which will keep us holding on target for the 395 for the full year. Okay. Thank you. And then can you just remind us your comfortability or where you're comfortable taking the balance sheet in terms of leverage? Yes. We've said our guide has been 1.5x to 2x debt to EBITDA and that allows us to remain investment grade and we think that's an important place to be in an uncertain world. And then we always put the caveat around that, that for the right opportunity to create shareholder value, we would look to go higher with the path to come back down. That it's an industry that others like a Goodman have gone private over the years a couple of times and have had debt to EBITDA maybe twice that amount and have been fine with it. And I think we would be too, but I don't think I'd want to do that just as a natural course of events. I think if we had something that could create real shareholder value, like an industry consolidating acquisition, we would think about it. But in a more normal course of business, I think the right balance approach is 1.5% to 2%. Great. Thank you. Thanks. Next we go to the line of Rich Kwas with Wells Fargo. Please go ahead. Hi. Good morning everyone. On price, so I think the guide implies $22,000,000 for the Q4. You did $27,000,000 in Q3. What drives it down in terms of contribution given the number of price increases this year? I think it's just the volume that the Q3 seasonally higher volume. Okay. And then the lap over benefit into 2019 should be meaningful, right? I mean, you'll be comping against some contribution, but it should be a decent contributor, right? That's the way we should be thinking about it. Yes. I mean, I think you could sort of shorthand, I would take the $50,000,000 that we initially gave and sort of assume how much of that was in first half of the year versus second half of the year. And then we've now raised it to 80, and that incremental 30 is all second half of the year. And you might even expect even sort of more back end loaded than that. So I think if you sort of do some of that and then you lay on top of that some new price that we would announce going into 20 19, I think you can start to back into a number that's going to be meaningful and, as I said, will offset the inflationary pressures we're feeling from commodities, freight and tariffs. Cost base should start coming down too as 'nineteen plays out, right, even with the hedges. Say again? The cost base should start getting incrementally improved even with the hedges as we start rolling through 2019, right? If commodities continue on the trend or on, yes. Yes. Okay. And then just on as you think about affordability, I mean, everybody's some have put through 3, you've put in a couple, you're going to put in another one, there's going to be another price increase on the residential side across the board, one would think at the start of the year. Any impact on mix as we think about mix has started to get better for everyone? How do you see this playing out over the course of 2019 on the resi side? I'm not sure I understand the question per se. Well, let's just say 13 SEER, I mean, is there does the incremental buyer come in on the remodel side and say, I'm not going to do 17 SEER, I'll do 14 SEER because mortgage rates are up and I'm not going to if I bought a house, I'm not going to up the ante with regards to the efficiency because the cost No, I think maybe on the margins, but I think when people sit down and do the economics on most markets or in the northern markets, you're going to be in the house 3 to 5 years, it makes sense to get a premium furnace. And if you're in the south and you're going to be in the house 3 to 5 years, it makes sense to get a premium air conditioner. And that's just the math of it. And I don't think that changes with incremental interest rates. The other point around our pricing power is, as you know, half the cost of a unit's labor, and they buy one every 15 years. So our ability to continue to raise price in the marketplace is driven more about at the dealer level and what competitors do rather than the homeowner. Homeowners want to accept it. Okay. All right. And then just last one real quick on commercial. Did you say new construction was down high single digits in the North America? Did I catch that right? Yes, correct. And I think that was serving a large part by national accounts. Okay, great. Thanks guys. Thanks. Next, we go to the line of Steven Whittaker with UBS. Please go ahead. Thanks. Good morning, guys. Good morning. Hey, Todd, I just want to come back to the consolidation comments again. So we've been talking about consolidation on and off for 20 years. The industrial logics generally always been there. If you sort of think about what dynamics have changed now to make that increasingly likely, despite some of the moves that have already taken place. What do you think are the biggest factors that would actually make that more realistic in the industry today than, say, it's been in the past decade? I'm just pausing to make sure I answer the question in a way that when the transcript comes back to me, I'm happy with what I said. So I think I'd Always wise. I think I'd answer it this way. We've always talked about focus wins and that the best place to be as a corporation is to be large enough to be at scale and then be focused on industries. And I think at least in my business life time, there's never been a time where the investment community feels the same way. And I think corporate leaders feel the same way. And so that's another way of saying industrial conglomerates are under pressure. And at least 2 players in our industry are owned by industrial conglomerates who, from everything I read, are reviewing their portfolio of businesses. And so I think there's sort of more optimism that maybe one of them or both of them will decide to do something with her portfolio that could make assets available. Okay. So willingness to sell on that front. So secondly, just going to the replacement demand a little more detail. I know it's going to be a little hard to tell with working through all of the mitigation actions and recovery on the tornado front. But just from a market level, I guess, as you and you talked about a little bit earlier, I think, on new construction. What are you seeing in terms of replacement demand on the resi front, resi light commercial too? On it still remains strong, Steve. And so July August, our replacement business is up mid- to high single digits. And then obviously, it slowed down in September, and that's what you see in the reported numbers. And I think September was warm enough and sort of a good enough month that my guess is our competitors will talk about a market that was up mid- to high single digits. And where are you thinking we are in terms of the overall cycle, again, exclusive of what you guys have been personally experiencing with the tornado? But as you sort of look out on the timing, how would you characterize it? What we publicly said and continue to be the case in my mind is that we think there's another 3 to 5 years of mid single digit growth in residential. And this reflects the echo of all those homes that were put in, in the new housing bubble in the early mid-2000s. And that continues to sort of bleed into the replacement market. And that analysis that we did has a bell shaped curve around this number, but on average, units last about 15 years before there's a catastrophic failure that has to be replaced. And so when we do all that math, we think it's 3 to 5 years of mid single digit growth. And again, that assumes sort of a neutral economy. It doesn't have to be 3.8% unemployment, just a solid economy. And then again, any given year, it can be swung by the weather, but we're still optimistic that this market still has legs. Next we go to the line of Ryan Merkel with William Blair. Yes, thanks. Two quick questions for me. So first, Todd, you said as the Iowa factory recovers, you will come out of this stronger than before. Can you just expand upon this? I think a couple of ways. One, maybe where you're leading me is we're building capability in our other factories to manufacture and fabricate parts for premium product. And I think that transfer of knowledge and capability is important for longer term capability of the company. I also just think that as we're sort of testing and challenging team members and they're rising to the occasion. And I just think the talent in our Iowa factory has been challenged and pushed. And my experience is the way you sharpen a blade is that way. And I think the blade of the Marshalltown improved. Got it. Okay. And then secondly, just to clarify, is the tornado impact a pretty solid estimate now in your mind? I think where I'm most solid on is our production ramp up, but that still has variables in it also. I mean, I'll be honest with you, there's still some pieces of equipment that are under wrap that we haven't broken out and started back up again after they've sort of been rained on and the tornado hit them. And so we still have some risk there. And then it's sort of our best guess on how the customer will play out. But I'd like to say, virgin territory for us, and we're giving you information as we know it. Understood. Okay. Thanks a lot. Thanks. Next question is from the line of Nigel Coe with Wolfe Research. Please go ahead. Thanks. Good morning. We've got a lot of ground here. Appreciate the detail, guys. I want to go back to price. I'd imagine that the problems you're having with the heating production makes this market very, very tight as we go into the heating season. So I'm curious whether pricing actually improves short term, I. E. In 4Q from the 3% you showed this quarter. And then as you then come back online in 2019, does that then put a little bit deflationary pressure on industry prices? I'm just curious if you could dig into pricing, maybe focus more on the near term pricing impacts. I think our guide of raising price from full year from $75,000,000 to $80,000,000 for the corporation, the $5,000,000 increase was really tied to residential and our ability to yield the price that we've already passed on. I don't think we'll give price back in 2019. I think we'll be the opposite. I think there will be another price increase and we'll get even more in 'nineteen. So I think short answer is we've recognized some benefit of price, increased price in 'eighteen. Maybe we do better, maybe we do a little bit worse, but we'll see, but that's our guide for today. And then in 'nineteen, we think we'll get even more price. But does the tightness in 4Q on the Heaton side mean that rebasing and discounting activity might be more moderate and therefore realized price goes higher in 4Q? I think our attempt on raising the price guide by $5,000,000 was our attempt to capture that. Okay. And then just quickly on tariffs. You have obviously minimal impact based on what you know right now. Are all of your China imports wrapped into the current lists 1 to 3 right now? So if we do get further actions, list 4, list 5, Are you pretty much done at this point? Ask the question one more time, please. Yes, I'm just wondering, your China imports, are they all covered by lists 1 to 3 or are there some other potential impacts if we do get a broadening of the tariff lists? I think the vast majority of what we import from China is impacted from List 1, 2 and 3. But there may be some that aren't impacted. So if we move to sort of if the administration moves to tariffs on everything imported from China, there's probably some more risk. Okay. And just a quick one. So Going back to the European weakness in commercial HVAC, is that a broad impact you've seen across the whole market there or is it just lumpiness? And any comments on that European weakness would be helpful. I think it's more broad in the European market. Early in 2018, there was a regulatory change in Europe regarding minimum efficiency and refrigerant policy, refrigerant that you can use. These changes combined added about specifically on our rooftop business there, which is our largest business, these changes combined at about 15% or so to the cost of a rooftop. And in the near term, leading customers slowed down their replacement cycle. So in 2018, there was some sticker shock as we and all our competitors had to make these changes in cost to the system. As we've started to sort of go through the year, the market is absorbing a new reality. And quite frankly, they have to replace the units that they have and build new stores. And so the year on year comparisons will start to become more favorable in Q4 and certainly as we go into 20 19. But I think in large part, it's an industry phenomenon. Next is the line of Walter Liptak with Seaport Global. Please go ahead. Hi, thanks. Good morning and thanks for taking my question. Of course. I was hoping to go back to the balance sheet and just get some detail about the receivables were up pretty nicely. And I think typically this time of year, there's some seasonality to it, but it looked better. I wonder what that was related to. And inventories presumably were down as you worked off any inventory that you were building for the heating season. But I wonder if you could talk about the inventory for the 4th and first quarter as well related to heating. And then with production ramping for heating next year in the Q1, is it early in the year or early in the quarter or is it late in the quarter? How do you miss the heating season because you're as you ramp in production? I'll answer the last part first. We're clearly missing some of the heating season, and that's reflected in the lost revenue guide that we've given. So short answer is we're missing some. Second point is we expect by the end of Q1 to be up and running in our heating production or have the capability to do heating production. And I would also say that we sell furnaces all year round. It's seasonal, but it's not as seasonal as air conditioners. Typically, when someone's going to replace system, if it's a 10 or 15 year old system, they'll buy a new furnace also. And so there's an attachment rate of furnaces that go with that. In terms of the working capital flow, it's going to be off from where it's been in prior years because of the tornado impact. But I think about inventory being down because we're selling out of our product. Receivables, a seasonal effect where we typically have big 3rd quarters and we did relatively not as well as we have traditionally done, but still up year over year revenue wise and that drove the receivable increase. And I'd say the impacts that you see on working capital are directly related to the impact of the tornado. And we have no further questions. You may continue. Okay, great. Thanks, operator. To wrap up, we look forward to a strong close to 2018 as we remain focused on executing on all our corporate initiatives to drive company performance and shareholder value. We hope to see everyone on December 12 at our Annual Investment Community Meeting in New York as we look ahead to 2019 and our long term plans. Thanks, everyone, for joining us today. Ladies and gentlemen, that does conclude your conference for today. Thank you for using AT and T Teleconference Service. You may now disconnect.