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 third quarter of 2018. I am here today with Chairman and CEO, Todd Bluedorn, 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&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.lennoxinternational.com. The webcast also will be archived on the site 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. 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 12th in New York City. Please mark your calendars. Invitations and more details will follow. The meeting will also be webcast.
Let me turn the call over to Chairman and CEO, Todd Bluedorn.
Thanks, Steve. Good morning, everyone. 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 third quarter 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 19th. Also make the overarching comment to keep in mind that the lost profits in 2018 and 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, one month after the tornado hit, we estimated the impact on our core business for 2018 of approximately $100 million of revenue and $55 million of segment profit and about $1.05 of EPS.
Our initial view is that about one-third of this impact would hit in the third quarter and about two-thirds would hit the fourth quarter. Further along, with more visibility, our current view is that the impact to our core business in 2018 will be approximately $115 million of revenue, $65 million of segment profit, and $1.25 of EPS. We now expect approximately 40% of this impact was in the third quarter and 60% will be in the fourth quarter. In the third quarter, we had $0.52 of tornado impact on our core business, which was 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 positioned than before. The change in the 2018 financial estimates come from a clearer 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 this 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 million of impact to revenue and $35 million 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, non-core special pre-tax charges related to the tornado are still expected to be approximately $80 million, offset by insurance proceeds in 2018. In the third quarter, we had $49 million of these charges offset by $49 million of insurance recovery. Below the line for 2019, we're estimating non-core special pre-tax charges relating to the tornado impact of $15 million. 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 $1.03 billion, 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 third-quarter record, $1.02 billion. Foreign exchange was neutral to revenue. On a GAAP basis, operating income was $145 million in the third quarter, down 6%. GAAP EPS from continuing operations was a third-quarter record, $2.65, up 8%. On an adjusted basis, total segment profit declined 3% to $155 million. Total segment margin was down 80 basis points to 15.2%. Adjusted EPS from continuing operations rose 8% to a third-quarter record, $2.72. Turning to the key points on our business segment for the third quarter. Our residential 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 replacement 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 to 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 million expenses on a year-over-year basis. Breaking down commercial revenue for the third 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 first quarter.
As is typical, not straight-line growth here. As we look at the first three weeks of October, the backlog is strong, up double digits, and we are tracking having a strong growth in the fourth quarter. For our local and regional commercial businesses in the third quarter, revenue was up mid-single digits. 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.
In Europe, constant currency revenue was also up mid-single digits, led by double-digit growth in our non-food refrigeration business. Refrigeration profit rose 19% in the third 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 third quarter. In the second quarter, we closed on the sale of our Asia-Australia businesses, as well as the sale of real estate in the Sydney area. Total net proceeds from these transactions were $116 million. Overall for the company, price cost was favorable in the third quarter. We had $27 million of price benefit, more than 2.5% 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 million to $80 million for the year. We plan to repurchase $100 million of stock in fourth quarter for a total of $450 million 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 third quarter 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 third quarter, revenue from residential heating and cooling was a third-quarter record, $595 million, 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 million, 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&A expenses. Turning to our commercial heating and cooling business. Commercial revenue was a third-quarter record, $276 million, up 2%.
Volume was up 1%, price was up 1%, and mix was flat. Foreign exchange was neutral to revenue. Commercial segment profit was $47 million, 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&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 third quarter was $153 million, 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 million, up 19%. Segment margin was 15.4%, up 190 basis points.
Segment profit was impacted by higher volume, higher price, sourcing and engineering-led cost reductions, and lower SG&A expenses. Partial offsets include higher commodity and freight costs. Overall, for the company, on an adjusted basis, the third quarter had a net after-tax charges of $2.4 million. This included $2.4 million for the net loss on the sale of business and related property, a total of $3.1 million for various other items, and a $1.7 million benefit for excess tax benefits from share-based compensation, and a $1.4 million net benefit for other tax items. Corporate expenses were $28 million in the third quarter, up from $24 million in the prior quarter. Overall, SG&A on a GAAP basis was $149 million in the third quarter or 14.5% of revenue, down from 15.1% in the prior quarter.
On an adjusted basis, SG&A as a percent of revenue was 14.4% in the third quarter, down from 14.5% in the prior quarter. Net cash from operations in the third quarter was $266 million, including $45 million in cash from insurance proceeds, compared to $177 million in the third quarter a year ago. Capital expenditures were $18 million compared to $17 million in the prior quarter, and free cash flow was approximately $248 million compared to $160 million in the third quarter a year ago. Total debt was $1.13 billion at the end of the quarter, and we ended September with a debt-EBITDA ratio of 1.9. Cash and cash equivalents were $46 million at the end of September. The company paid $26 million in dividends in the third quarter. Before I turn it over to Q&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%-4% and for an adjusted revenue growth of 4%-6%. We are updating our 2018 guidance for GAAP EPS from continuing operations from $8.38-$8.78 to a new range of $8.11-$8.51. We are updating 2018 guidance for adjusted EPS from continuing operations from $8.90-$9.30 to a new range of $8.70-$9.10. The updated GAAP and adjusted EPS ranges include the additional $0.20 of tornado impact expected this year, $0.17 of which were in the third quarter.
This will be a benefit to 2019 upon receipt of insurance proceeds next year. 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 million-$80 million on even more confidence on capturing yield this year. As we look ahead to 2019, our commercial business has already announced a price increase of up to 4% to be effective January 1st. For commodities, we now expect $45 million of headwind for the full year, down from our prior guidance of $50 million. Freight expenses are now expected to be $25 million for this year, up from the prior guidance of $20 million. We now expect $30 million of savings from our sourcing and engineering-led cost reduction programs, down from prior guidance of $35 million.
For the 2018 guidance points that remain the same, foreign exchange is expected to be neutral for the year. Tariffs are still a $5 million headwind for 2018. We still see $7 million 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 million headwind. SG&A is still expected to be about $10 million over last year, and the corporate expense target for this year remains approximately $85 million. Just a few other guidance points. Net interest expense is expected to be a bit over $35 million for the full year. Tax rate guidance remains 22%-24% on an adjusted basis for the full year. Capital expenditures are still planned to be approximately $100 million, excluding the impact of the tornado repairs.
We are planning a total of $450 million stock repurchases for the full year and are reiterating guidance for an average diluted share count of approximately 41 million shares on a full-year basis. We are still targeting approximately $395 million of free cash flow for the full year. With that, let's go to Q&A.
Ladies and gentlemen, if you would like to ask a question, please press star then one on your telephone keypad. You will hear a tone indicating you have been placed in queue, and you may remove yourself from this queue at any time by pressing the pound key. Our first question is from the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead.
Hey, good morning, guys.
Hey, Jeff.
Hey, on the impact, one, what's informing the higher amount for 2018? The $85 million, what does that imply that you'll be back to normal production by? Just also, it looks like you're using lower incremental margins or margins on the 2019 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 2018 guide for the tornado impact? I think I'd answer it a couple ways. One is the first guide we gave was about three weeks after the tornado, and we did a high-level estimate of round numbers, and I sort of made the point $100 million was a big round number, $100 million of revenue and $55 million of segment profit or $1.05 of EPS for 2018. We refined those estimates now that we're several, two, three months into this thing. We've gotten further along and have a clearer view, quite frankly, on the customer dynamics in the near term.
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 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 that 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 Saltillo, 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.
For cooling products, we expect Lennox to be back up to full pre-tornado production capability early in fourth quarter in 2018, so here in the next month or so. For heating products, we expect Lennox to be back up to full production capability in first quarter of 2019. We will have a bit of lag from the perspective of fully meeting market demand due to having to catch up on rebuilding our inventory in the channel. Sort of the tornado impact, if you will sort of bleed into second quarter, even though we're up to full production, as we'll have to sort of ramp up to build even more inventory. I think the other question is, why was the drop-through different in 2019 versus 2018? This is a function of the mix of products and the product tiers impacted.
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. Hopefully, I think that's everything you asked.
Yep.
Okay.
Yeah, you covered it great. Can you just talk about 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 2019? I'll get back in queue. Thanks.
We lowered the material cost reduction bucket just reflecting sort of more inflation, because again, this is always a net number. I also mentioned on the call that third quarter we turned the corner. I got quarter and corner mixed up. In third quarter, we turned the corner and had $27 million of price more than offset commodities, freight.
Tariffs.
Tariffs, excuse me. 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. 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. Price, commodities, tariffs, and freight will be a net positive to us in 2019.
Thanks a lot.
Thanks, Jeff.
Next we go to the line of Steve Tusa with J.P. Morgan. Please go ahead.
Hey, guys. How's it going?
Hey, Steve.
Thanks for all the detail on the unfortunate situation there. Just on the market, you guys were down in resi in new housing-related business. Can you maybe just discuss what you think kind of the markets have done this quarter? 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 two, new housing versus replacement in resi.
I think it's split between the two. We really started seeing a tornado impact in September. The vast majority, I don't want to say all, but the vast majority of the tornado impact was in September. In July and August, we were off to a strong start in residential, both in new construction in and add-on replacement. To give a read through to the other guys, I think the market was pretty strong in the third quarter. July and August, we are up mid to high single digits in residential, both segments of the marketplace. Then obviously we saw as we started to run out of equipment, we saw the impact in September. I think the weather was reasonably good in September, so I think overall, the market was probably strong for the quarter.
Got it. Then with regards to tariffs, this new round that's come out, or at least the new couple rounds, I can't even keep track anymore, but how are you 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 million. That's the guide. Again, that's included what's been implemented, what's been announced with detail, but doesn't include any tweaks that sort of even add more to it than that. It's what you can do the math on. We think the 2018 order of magnitude is going to be $5 million. 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. The other point I 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.
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 the net number. The order of magnitude $5 million is what we expect to see on the P&L.
Okay.
We haven't guided yet on 2019, but I would sort of take over twice that amount if I was building a model and assume that for 2019.
Okay. Again, just to be clear on this, because everybody's 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?
Correct.
That would reflect the incremental. Okay. Got it. 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'd unpack it a couple ways. To that question I'd say, which is a direct question, customers expect price increases, several of our competitors have announced some things. We announced in commercial big. They're not surprised. They're accepting it, point one. Point two is we raised our price guide in 2018 from $75 million to $80 million, that $5 million, I think I'm comfortable saying it's exclusively residential. Quite frankly, we didn't have to announce a price increase. It's always about the yield and how you hang on to it. We're getting better price yield in residential, just like we speculated we might, given the shortage of inventory. 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.
As we go into 2019, 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 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 four 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 four 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 a question, I answered a question. I don't know York's residential market share, but I think it has one digit in it. I think they could combine with other players in the industry. Certainly could combine with us. I think their commercial unitary share starts with one digit. Their applied is a larger part of the business. The York business could certainly combine with us. When I look at the other residential businesses, it's other players. Again, I think they could combine with York or maybe even us. I think that was sort of the broad question of did I think anything was prohibitive? Are there things that couldn't happen? Certainly.
Are there combinations that could happen? Certainly.
Right. I guess you commented on York very specifically. Can you comment on Carrier very specifically?
Their share starts with two digits. I know that. Beyond that, I'm not exactly sure where they're at. My guess is they could combine with us. Well, certainly they could combine with York, I think they could combine with us, but I don't know that for certain.
Okay.
It also depends what's being enforced at the time. 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 thread.
You guys are feeding frenzy on this side.
I know.
On this business consolidation
at least we're not talking about tornadoes, right?
Yeah. I know for a fact Greg knows the Carrier share, you should ask him.
We think you know it too, we won't press you. Does consolidation make sense? What would be gained in your view given this great pricing discipline that we're observing, especially in the resi business?
Well, industry consolidation, obviously with the caveat of at the right price, but I think it'd be traditional horizontal integration of an industry. I would view it as distribution forward, so consolidating factories, consolidating supplier spend, taking out SG&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. I just think traditional cost takeouts in an assembled product business like we have, I think you could create lots of synergies. Then again, it'd have to be at the right price. I think it's clear industrial logic of how we take out costs.
How about on the distribution side, Todd? Some companies have chosen to third-party their distributions. Others, like you, own it. Putting that type of footprint together, do you see any particular challenges there?
My experience having 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. My perspective on it would be in an industry like this, when you consolidate, that there'd be some period of time you'd leave distribution alone. Whatever it was, you'd optimize it and manage it as it was. I don't think you'd want to go from one model to another model quickly. The investments that a company was making in digitization and support of your contractors, whether it was company-owned distribution, a JV, or independent distribution, you could leverage those investments with those distributors. I don't think you'd have to physically make a change in distribution to leverage some of the investments that a company was making.
Just one on the quarter from me, just to make sure I've got my head around really what's going on in your margins, right? 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? We can 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? I'm just trying to understand the composition of that in resi.
I'll ramble and see if I answer the questions. Margins were down because of the tornado impact on revenue and the corresponding impact on EBIT is why they were down. Even from the guide that we'd given earlier, which was $120 million and $55 million of EBIT, a third of it in fourth quarter, we're now saying it's 40% in third quarter and the overall number is going up to $65 million of EBIT and $120 million of revenue. We performed extremely well in residential. 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. Maybe just trying to stick to two questions. The first one on the commercial business, if there was any extra color you could give on U.S. trends as they stand today. Also on the margin front, margins were down a bunch in the third quarter. How quickly do you think that comes back? Any extra detail you can give on the factory productivity you cited?
First talking about commercial, I talked about it in the call I think in some detail. It's just the lumpiness in national accounts. We feel confident in fourth quarter. Still a lot of work in front of us, but through the first three weeks of our quarter, backlog is strong, up double digits, we're tracking to have another strong revenue quarter for commercial in fourth quarter. First quarter, we were flattish in commercial. Second quarter, we were up 18%. Third quarter, we were flattish. In fourth quarter, we're going to have strong revenue growth. In terms of the margin, as I mentioned in the call, was impacted by a couple things. One was the timing of some expenses, just sort of year-over-year differences of when you make adjustments for expenses like warranty and LIFO without getting too accounting on you.
The other one, I think more operational, was we had some factory productivity issues in third quarter. Really what's driving the factory productivity issues is we're seeing labor shortages in our Stuttgart facility. We've been addressing it with overtime and extra shifts to be able to meet customer demands. 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. The issue around labor productivity and not having enough folks will have impact in Q3, we'll also see it bleed off into Q4. On the fourth quarter call, I'll also be talking about this because it just takes a while to get it in place. We expect to have it fully resolved by first quarter 2019.
Thank you for the detail. My second question would be on refrigeration. One of your peers had talked about the retail refrigeration market maybe bottoming out. Your own revenue growth numbers suggest you're taking some share. Maybe just any commentary on how you see the market in U.S. retail refrigeration.
I still think it's tough. Dover refers to it as retail refrigeration. We refer to it as grocery. I assume that's what you're talking about. That has the biggest impact in our Kysor/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. It's not the retail segment or the grocery segment. It's sort of other parts of the cold storage channel, cold chain, cold storage market where we've seen the growth.
Great. Thank you.
Thanks.
Next is the line of Gautam Khanna with Cowen. Please go ahead.
Thanks. Good morning.
Hey. Hey, Gautam. How are you?
Doing well. I was wondering, Todd, could you just talk a little bit about your confidence level in recapturing 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 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?
Yeah. We're working hard to do that. As I've spoken about before, you've heard me say it, Gautam, 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. We don't want to run out of equipment and then have them feel the pain. We'll feel the pain and allow them to move over. I think that honest, open communication helps a lot. Then the second thing's going to be on the flip side, that as we reach full production capability, and as I spoke about we expect air conditioners in fourth quarter and furnaces in first quarter, we'll 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. 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. Then when we come back online, they'll move the share back to us.
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 a laser-like focus in 2019, but we're committed to doing that.
Okay. 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, it's a little early to sort of speculate or even give guide, because the order book tends to fill up three, four, five months ahead of itself, so 2019's still very early. 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've reduced our exposure to that, it's still about half of our national account business. Getting a better take on the Christmas selling season will help us. All that being said, retail's strong right now. Consumers are spending money. Consumers feel good. Retailers are spending money on things they weren't a year or two ago in our industry. We feel pretty good as we go into 2019, but we'll give more of a guide at the December Analyst Day.
Thank you.
Thanks.
We go to the line of John Walsh with Credit Suisse. Please go ahead.
Hi, good morning.
Hi. Morning.
I apologize if I missed it, 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 how it's going to impact. I would point out we had a very strong quarter in cash generation in third quarter. We continued to generate cash. We still haven't put a fine-tooth answer about the inventory bleed out and then the inventory rebuild. The only point we made on cash is that the below the line impact of $80 million, I'm looking to make sure I have that number right, that we'll expect to have enough minimum cash proceeds to offset that. We'll be neutral on cash on the below the line charges, if you will. Third quarter, we saw that 47/47 on the offsets.
For the above the line impact, 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 insurance companies in cash in 2019.
We're compensating with the lost profits, which are our 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. Can you just remind us your comfortability or where you're comfortable taking the balance sheet in terms of leverage?
Yeah, we've said our guide has been 1.5 to 2 times debt to EBITDA. That allows us to remain investment grade, and we think that's an important place to be in an uncertain world. Then we always put the caveat around that for the right opportunity to create shareholder value, we will 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 times and have had debt to EBITDA maybe 2 times that amount and have been fine with it. 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.
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.
Hey, Rich.
On price, I think the guide implies $22 million for the fourth quarter. You did $27 million 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 third quarter seasonally higher volume.
Okay. Then the lap over benefit into 2019 should be meaningful, right? 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?
Yeah. I think you could sort of shorthand, I would take the $50 million that we initially gave and sort of assume how much of that was in the first half of the year versus second half of the year. Then we've now raised it to $80 million, and that incremental $30 million is all second half of the year. You might even expect even sort of more back-end loaded than that. I think if you do some of that and then you lay on top of that some new price that we would announce going into 2019, 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 2019 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 they're on, yes.
Yeah. Okay. Then just on as you think about affordability, some have put through three, 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, it's 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. 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 if I bought a house, I'm not going to up the ante with regards to the efficiency because the cost is.
No, I think maybe on the margins. I think when people sit down and do the economics on most markets or in the northern markets, you're going to be in a house three to five years, it makes sense to get a premium furnace. If you're in the South and you're going to be in a house three to five years, it makes sense to get a premium air conditioner. That's just the math of it. I don't think that changes with incremental interest rates. The other point around our pricing powers, as you know, half the cost of a unit is labor, and they buy one every 15 years. 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 willing to accept it.
Okay. All right. Just last one real quick. On commercial, did you say new construction was down high single digits in North America? Did I get that right?
Yeah, correct.
Okay.
I think that was driven in large part by national account.
Okay, great. Thanks, guys.
Thanks.
Next we go to the line of Steve Winoker with UBS. Please go ahead.
Thanks. Good morning, guys.
Morning.
Hey, Todd. I just want to come back to the consolidation comments again. We've been talking about consolidation on and off for 20 years. The industrial logic 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.
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. I think, at least in my business lifetime, there's never been a time where the investment community feels the same way. I think corporate leaders feel the same way. That's another way of saying industrial conglomerates are under pressure. At least two players in our industry are owned by industrial conglomerates, who, from everything I read, are reviewing their portfolio of businesses. I think there's sort of more optimism that maybe one of them or both of them will decide to do something with their portfolio that could make assets available.
Willingness to sell on that front. Secondly, just going to the replacement demand in a little more detail. I know it's got to be a little hard to tell with working through all of the mitigation actions and recovery on the tornado front. Just from a market level, I guess, 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?
It still remains strong, Steve. July and August, our replacement business was up mid to high single digits. Obviously it slowed down in September and that's what you see in the reported numbers. 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.
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. As you sort of look out on the timing, how would you characterize it?
What we've publicly said and continue to be the case in my mind is that we think there's another three to five years of mid-single-digit growth in residential, this reflects the echo of all those homes that were put in the new housing bubble in the early mid-2000s. That continues to sort of bleed into the replacement market. That analysis that we did, there's a bell-shaped curve around this number, but on average, units last about 15 years before there's a catastrophic failure that it has to be replaced. When we do all that math, we think it's three to five years of mid-single-digit growth. Again, that assumes sort of a neutral economy. It doesn't have to be 3.8% unemployment, just a solid economy.
again, any given year, it can be swung by the weather, but we're still optimistic that this market still has legs.
All right, thanks, Todd. I'll pass it on.
Thanks, Steve.
We go to the line of Ryan Merkel with William Blair. Please go ahead.
Yeah, thanks. Two quick questions from me. 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 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. 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. I think the blade of the Marshalltown factory is being sharpened and our capabilities are just being improved.
Got it. Okay. 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'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. We still have some risk there. It's sort of our best guess on how the customer will play out. I'd like to say we got all the snow down, but this is 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 tight as we go into the heating season. I'm curious whether pricing actually improves short term, i.e., in 4Q from the 3% you showed this quarter. As you then come back online in 2019, does that then put a little bit of deflationary pressure on industry pricing? I'm just curious if you could just dig into pricing and maybe focus more on the near-term pricing impact.
I think our guide of raising price from full year from $75 million to $80 million for the corporation, the $5 million 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 it'll be the opposite. I think there'll be another price increase, and we'll get even more in 2019. I think short answer is we've recognized some benefit of increased price in 2018. Maybe we do better, maybe we do a little bit worse, but we'll see. That's our guide for today. In 2019, we think we'll get even price.
Does the tightness in 4Q on the heating side mean that rebating 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 million was our attempt to capture that.
Okay. Just quick 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? If we do get further actions of list 4, list 5, are you pretty much done at this point?
Ask the question one more time, please.
I'm just wondering, your China imports, are they all covered by lists one to three, 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 do import from China is impacted from list one, two, and three. There may be some that aren't impacted. If the administration moves to tariffs on everything imported from China, there's probably some more risk.
Okay. Just a quick one, Todd. Going back to the European weakness in commercial HVAC. Is that a broad impact you're seeing across the whole market there, or is it just lumpiness? 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 in 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 added about 15% or so to the cost of a rooftop. In the near term, leading customers slowed down their replacement cycle. In 2018, there was some sticker shock as we and all our competitors had to make these changes and add cost to the system. As we've started to sort of go through the year, the market's absorbing a new reality, and quite frankly, they have to replace the units that they have and build new stores. The year-on-year comparisons will start to become more favorable in fourth quarter, and certainly as we go into 2019.
I think in large part, it's an industry phenomenon.
Got it. Thanks, Todd, and good luck with recovery.
Thanks.
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.
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. Inventories presumably were down as you worked off any inventory that you were building for the heating season. I wonder if you could talk about the inventory for the fourth and first quarter as well related to heating. With production ramping for heating next year in the first quarter, is it early in the year or early in the quarter, or is it late in the quarter? Do you miss the heating season 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. The short answer is we're missing some. Second point is we expect by the end of first quarter to be up and running in our heating production or have the capability to do heating production. 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 an air conditioning system, if it's a 10- or 15-year-old system, they'll buy a new furnace also. 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.
I would think about inventory being down because we're selling out of our product. Receivables, a seasonal effect where we typically have big third 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 increases.
I'd say the impacts that you see on working capital are directly related to the impacts of the tornado.
Okay. All right. Great. Thank you, guys.
Thanks, Walter.
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 12th 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.
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