Trane Technologies plc (TT) — Q2 2016 Earnings Call Transcript

Thanks and good morning, everyone. This is Zac Nagle, and it's a pleasure to join you for my first Ingersoll Rand earnings call as Vice President of Investor Relations. Welcome to Ingersoll Rand's Second Quarter 2016 Earnings Conference Call. We released earnings this morning at 6:30 a.m., and the release is posted on our website. This call is also being webcast and archived on our website at ingersollrand.com, where you'll find the presentation accompanying our comments this morning. Please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our SEC filings for a description of some of the factors that may cause actual results to differ materially from anticipated results. The presentation also includes non-GAAP measures, which are explained in the financial tables attached to our news release. The participants on this morning's call are: Mike Lamach, Chairman and CEO; Sue Carter, Senior Vice President and CFO; and Joe Fimbianti, Director of Investor Relations. With that, please go to Slide 3 and I'll turn the call over to Mike.

Great. Thank you, Zac, an official welcome to Ingersoll Rand and your first earnings call with us. As you can see from our earnings release this morning, we had another excellent quarter. We had outstanding execution across the company delivering 15% EPS growth, record operating margin, share gains and strong cash flow despite challenging industrial markets. We're seeing strong momentum in the operating system that we've been installing and developing in the company over the past 6-plus years. As we did last quarter, I'd like to start out spending a few minutes linking this quarter's performance to the longer-term strategic direction of the company to help investors understand how we're building a more valuable, sustainable and less cyclical company over the longer term. Within our operating system, operational excellence and growth excellence have been cornerstones of the strategy from the beginning, with our goal of becoming the very best operating company within our diversified or multi-industry peer group. This quarter we continued to deliver best-in-class operating leverage of 47% and our goal is to achieve top quartile organic growth for the quarter and for the year as well. There were a number of noteworthy milestones that showed clear progress in these areas during the quarter. Our residential HVAC business had another outstanding quarter with record revenue and profitability. We estimate that over the past quarter and 12 months, we now have benchmark profitability in this business and are seeing the benefits of a 5-year effort to refresh the product line, align and reposition the channel and dramatically improve product management, manufacturing and supply chain. Our residential business is also a model for the deployment of product growth teams for delivering market share and margin growth. Our commercial HVAC business in North America had record second quarter bookings and revenue. Similar to our residential HVAC story, we have executed on a consistent strategy with the goal to have the freshest, most energy-efficient and reliable product line in the industry and have supported that with consistent operational improvements along the way. We continue to see double-digit increases in our controls business and high single-digit growth in our service business, consistent with our strategy to balance equipment with controls and services. In the second quarter, Trane Commercial led the industry with a strong pipeline of new high-efficiency products, many of which earn our EcoWise badge for innovation that improves energy efficiency as compared to legacy product platforms, while reducing greenhouse gas emissions. Examples this quarter include the North American announcement of the new CenTraVac centrifugal chiller portfolio using next-generation low global warming potential refrigerant. The product is for large buildings and industrial applications in the U.S. and Canada. We also announced a service program to retrofit the existing installed base to the next-generation low global warming potential refrigerant, which protects and provides a viable option for our customers' past investment while achieving their own sustainability goals. In Europe, we announced another 4 new products, the Sintesis eXcellent, a new air-cooled chiller with nearly 0 global warming potential using next-generation refrigerants. Airfinity, a complete new range of HVAC rooftop units designed to comply with the upcoming European Union EcoDesign regulations. They're light, compact and modular plug-and-play HVAC units that are compatible with wireless technology and designed to save time and money when retrofitting, and improve the efficiency of existing buildings across Europe. XStream, a new range of water-cooled screw chillers now available in Europe and the Middle East. The efficiency and capacity ratings are unmatched by any other screw chiller in the market today. We hope this will become a preferred option for critical applications like data centers, hospitals, process cooling, district cooling and heating. And finally, Trane Balance, our second generation of innovative multi-pipe systems for high-efficiency simultaneous heating and cooling. The systems repurpose energy that's rejected and use renewable energy for heating. Within our Thermo King North America, Europe and Middle East business, we're demonstrating that we have a more resilient business than in the past, expanding margins 270 basis points in a low-growth environment. As we noted in our initial guidance, we believe that we could maintain or even grow margins with a 15% North American trailer pullback and flat overall volumes. Today, the Thermo King business serves the refrigerated truck, trailer, marine container, air container, bus and rail, telematics and auxiliary power unit markets. And the completeness of the portfolio has added to margins and the overall resiliency of the portfolio. Also of interest, both our residential HVAC and Thermo King North America, Europe and Middle East business units have been fully deployed on the new ERP system for the past couple of quarters, and we believe we're now seeing the expected productivity throughout these business units. We continue to deploy new sites routinely in other business units each quarter. We continue to be pleased with the tremendous execution we're seeing in our HVAC and transport refrigeration business in Asia Pacific and in Latin America. Both regions demonstrated substantial margin improvement and share growth. HVAC bookings in Latin America were up 36% on an organic basis for the quarter, really outstanding performance by that team and that region. In Asia Pacific, our transport refrigeration business continues to grow with another 23% increase in bookings and a 25% increase in revenue. Both are examples of finding pockets of growth within generally weak markets and then capitalizing on those opportunities. Turning to our Industrial segment. I want to start by saying that I have tremendous confidence in our leaders running these business units. They're operating in a very challenging environment. Within compression technologies in North America, it's our largest market for equipment, the 250-horsepower to 400-horsepower contact-cooled rotary market is down 20%. And all other size ranges are also down in the high single-digit range, with only small 5- to 15-horse compressors showing year-over-year growth. Against this backdrop, we're performing well and supplementing the business with service bookings of approximately 10% in the quarter. Remember, too, that the last time we emerged from down industrial cycle, we grew margins nearly 7 full points in a 24-month period. Our Fluid Management business continues to perform well with modest growth, and we're seeing continued weakness in the tools business. And no sign of recovery in our Material Handling business, which provides hoists and winches for the oil and gas industry. Club Car continues to broaden its strategy and reach outside of golf with small electric vehicles in the commercial and consumer segments. Turning to growth excellence, which encompasses the full value stream from strategic analytics, product management, new product and technology introduction, sales management and service and support, this has been another cornerstone to our long-term strategy. We believe the product, channel and service footprint investments we have made over the past 5 to 7 years are paying off. It's clearly evident in the HVAC and transport refrigeration business units. And we believe it'll also be the case for our compression technology business unit that has been doing a similar investment program over the past couple of years, which will continue over the next several years. Even as industrial markets are challenging today, we continue the investment in the compression technologies business because we expect we'll be rewarded as the market recovers. As one example, one of the product growth teams operates in the compression technology business and covers a specific product portfolio, which equates to about 10% of the overall revenue of that business. Within the product growth team, we're seeing year-to-date bookings increases of 30% and revenues increasing by 17%. It's strength in our Climate segment, capacity utilization in our shared Climate and Industrial plants and operations and leveraging our technology teams, that's allowing us the opportunity to stay the course on critical growth programs in our Industrial segment. We have continued to invest in strategic growth programs across the company through both good and difficult times and the benefits of doing so are clear. Our designated strategic growth programs, many of which are managed through our product growth team process, are growing at a rate three times faster than the underlying growth rate of the company. As another example, within the commercial HVAC business in North America, Europe and the Middle East, our strategic growth programs are growing at a 14% rate this year. And for the company, over 80% of our growth is coming from investment and focus on these critical strategic growth programs. So as is our model, we'll leverage the success and build and accelerate on the full deployment of this element of our operating system in the years ahead. Going forward, we see multiple investment opportunities to deliver long-term growth through innovation and differentiation of the products, software and services we provide. I don't think anyone on this call needs another presentation on the Internet of Things and the possibilities for how that will transform competition and opportunity. This macro trend is squarely centered on nearly every growth and productivity strategy in our company, whether it's connected buildings, intelligent monitoring and service, diagnostic and self-healing systems, telematics, consumer marketing and fulfillment and too many other digital concepts to list. We're funding a number of these ideas centrally within the corporate expense line and are likely to accelerate this incubation investment later this year. Incremental 2016 investment for this activity is already embedded in our guidance. Finally, building on the culture element of our model. High-quality teams and deep employee engagement are critical to any sustained transformation, and I'm pleased that we continue to excel in these areas. One source of great pride within Ingersoll Rand is our ability to walk the talk on sustainability. To make a point, we continue to see benchmark levels from employee engagement; world-class safety performance for any segment of industry; energy reduction of 5% on an absolute, not volume-adjusted basis; a 14% reduction in water consumption, also on an absolute basis; and similar reductions on both hazardous and nonhazardous wastes. So Sue will take you through the quarter in detail. I felt it was important to align how today's results reinforce the strategy of the company, how we intend to get delivering great results and why you should believe we're building a more valuable, sustainable and less cyclical company for our shareholders. With that, I'll turn it over to Sue.

Thank you, Mike. Let's go to Slide 4. This is a summary slide that I like to begin with and give you some takeaway from today's call. As Mike has discussed, Q2 was another strong operational quarter for us and it shows through the financial results that we posted. In the second quarter, we drove year-over-year organic revenues higher by 3%, adjusted margins up 80 basis points with a leverage of over 45% and adjusted earnings per share up 15% against the backdrop of a very slow-growth environment and particularly challenged industrial markets. Adjusted earnings per share of $1.38 exceeded our guidance range of $1.27 to $1.32 by $0.08 at the midpoint and $0.06 at the high end. Our $0.08 beat versus our midpoint was driven by exceptionally strong performance in our Climate segment, partially offset by challenged markets in our Industrial segment and about a $0.06 beat from a lower tax rate in the quarter. We believe we will maintain a 200 basis point lower average tax rate than our previous guidance of 24% to 25% for 2016. We also reported strong year-to-date free cash flow of $348 million, which is an increase of $293 million from the prior year. Our focus on working capital management and our business operating system has contributed to this performance. As a result, we are raising our free cash flow forecast to $1 billion to $1.1 billion, excluding the proceeds from the sale of Hussmann. Turning to segment results, the Climate segment continues to exceed expectations, primarily due to excellent execution in both commercial and residential HVAC, with mid-single-digit and high-single-digit growth, respectively. Margins have also expanded healthily, driven by strong volume, productivity improvements, and material deflation of nonferrous commodities. Additionally, we have continued to invest in the business to achieve sustainable growth. The Industrial segment's end markets are more challenged than previously forecast and we experienced negative growth in all the major end markets, except small electric vehicles, which is our Club Car business, and Fluid Management where we continue to see growth. Across Industrial, we continue to take measures to drive productivity, shift our mix further towards more profitable aftermarket services and parts markets and to make prudent cost reductions in the business. We continue to be committed to a dynamic capital allocation strategy focused on delivering high returns to shareholders over the long term. Our strong free cash flow generation and cash balances provide us important options as the markets evolve. And lastly, we bumped up at the bottom end of our guidance range by $0.05 and our current adjusted continuing operations earnings per share for 2016 is $4 to $4.10. This update reflects expected continued strong growth in our Climate segment and tailwinds resulting from a lower go-forward structural tax rate of 22% to 23%, partially offset by continued weakness in our Industrial end markets, where we're not seeing the signs of recovery we had originally anticipated in our prior guidance. Now if you'll go to Slide 5. Let's begin discussing additional details regarding the second quarter. Our business operating system again guided us through good execution in our factories and in our cost centers. Our focus was on good operating results in a low-growth environment and we delivered against that objective. Enterprise revenues were up 3% organically with Climate up 5% and Industrial down 3%. HVAC revenues grew in each of our Climate businesses, led by commercial and residential HVAC in North America. Thermo King North America and EMEIA truck and trailer revenues continued to be strong in the quarter. Industrial markets declined in the quarter, consistent with the overall market. Club Car performed as expected, with mid-single-digit growth year-over-year. Our adjusted operating margins grew 80 basis points year-over-year with operating leverage exceeding 45%. Our strength in margin expansion was driven through price realization, productivity gains and direct material deflation. We've inserted a margin table on the slide and that'll illustrate some of the items I just talked about. We completed the sale of our remaining interest in Hussmann on April 1, 2016, for a gain of approximately $398 million. Let's go to Slide 6. Orders for the second quarter of 2016 were up 3% organically. Climate orders were up 6% organically. Organic global commercial HVAC bookings were up high single digits, similar to the first quarter, led by low-teens growth in North America, Applied and unitary, and strong growth of 36% in Latin America, which was against a relatively easy compare in 2015. Asia bookings continue to be lumpy from quarter-to-quarter and were down in Q2 overall, while China was up low single digits. We continue to see excellent growth in service, controls and contracting with low-teens growth in the quarter. Residential bookings were up low teens, representing the fourth consecutive quarter of bookings growth above 10%. Organic transport orders were down mid-single digits with order growth in overseas markets offset by declines in North America trailer and auxiliary power units. Consistent with the expectations we set out earlier in the year, we continue to expect bookings to decline in North America trailer in the second half of the year, and this is built into our guidance. Transport orders in Asia were up 23% in the second quarter. Overall, we anticipated some recovery in the Industrial markets as we moved through Q2 and the balance of the year, but we're seeing continued challenges and market declines. Net orders in the Industrial segment were down 5% organically. We saw high single-digit order decline in compression technologies and services. Services continued to be a bright spot and were up high single digit as we continue to focus on the business with higher-margin product streams. We saw low-teens decline in other Industrial products and a high single-digit increase in Club Car. Now if you'll go to Slide 7, please. This slide provides a directional view of our segment revenue performance by region. In our Climate segment, which was up 5% in the second quarter, we saw solid performance in North America and low single-digit growth across Europe, Asia and Latin America. We saw a decline in the Middle East, consistent with the contraction in the number of building projects planned, primarily in Saudi Arabia, and we expect this to continue for some time as low oil prices are driving an investment pullback. Our Industrial segment performance in the second quarter, which was down 3% is representative of the ongoing volatility and declining markets that continue across the globe in industrial markets. Our regional industrial markets declined except for Europe and Asia, which were up. Let's go to Slide 8, please. Climate revenues of $2.9 billion for the quarter were strong, up 5% organically. Commercial HVAC organic revenues were up mid-single digits, led by 20% growth in North America in contracting and upper single-digit growth in unitary equipment shipments in North America. Europe had equipment growth in the mid-teens and high single-digit growth in services, contracting and parts. The Middle East revenues declined largely due to a share pullback in Saudi Arabia, as I mentioned earlier. Residential revenues were at record levels and up high single digits in the second quarter. Transport organic revenues were up low single digits in the quarter. Truck and trailer organic revenues were up high single digits overall, with improved revenues in North America, Europe and Asia. We also had a high single-digit improvement in aftermarket volumes. Marine container organic revenues declined more than 60% in the second quarter, reflecting a soft first half at various box builders for 2016. We also had lower sales auxiliary power units reflecting the decline in the Class 8 sleeper market. Please go to Slide 9. Our Climate operating margins grew 250 basis points year-over-year. Our strength was broad-based, based on volume, price, direct material deflation and productivity gains, and we continued to invest in the business for sustainable growth. Please go to Slide 10. Second quarter revenues for the Industrial segment were $753 million, down 3% on an organic basis. Compression technologies and services organic revenues were down low single digits versus last year. And industrial products were down mid-teens with growth in Fluid Management and declines in Material Handling equipment and tools. Small electric vehicles, also known as Club Car, organic revenues were up mid-single digits versus prior year from gains in equipment and aftermarket. Regionally, the decline in organic industrial revenues was led by a mid-single-digit decline in the Americas and the Middle East. Asia and Europe were up modestly, partially offsetting the declines. Please go to Slide 11. Industrial's operating margin of 9.1% was down 250 basis points compared with last year. Lower volumes were the largest driver, partially offset by pricing, material deflation and productivity. Despite the downturn, we continued to invest in the business for the long term. Additionally, capitalized costs related to new product engineering and development were reclassified to the income statement in Q2, which were a drag on margin of approximately $8 million or 1.1 percentage points for the Industrial segment. Excluding this adjustment, Industrial adjusted margins were 10.9% in Q2. Moving forward, we expect Industrial segment performance to trend with the market. We're planning on expanding margins in a down market in the second half of the year through aftermarket growth, productivity gains and cost controls. Please go to Slide 12. Our June year-to-date free cash flow of $348 million was favorable to prior year by $293 million. Strong operating income improvement and improved working capital performance were the primary drivers of the favorability. Because of our strong start to the year, we have raised our free cash flow forecast range to $1 billion to $1.1 billion from our previous range of $950 million to $1 billion. For the quarter, working capital as a percentage of revenue was 5.6%. We had strong collections in the quarter with our days sales outstanding improving 0.6 days over the prior year and days payable outstanding improving 0.7 days. Inventory is on plan for the quarter, and we're well positioned to serve our customers. Please go to Slide 13. Our cash performance in the second quarter and our expectations for the year allow us to continue investing in the strategic growth programs that Mike outlined earlier. In addition to our core strategic investments, we are also prioritizing long-term growth through innovation and differentiated products in areas such as connected buildings, intelligent monitoring, and self-healing systems, among others. We will also maintain a strong balance sheet with BBB credit metrics, and we will retain the flexibility to pay a competitive dividend, pursue acquisitions to grow the business, and conduct share repurchases. Please go to Slide 14. As always, our intention is to give you our best view of what we're seeing in our end markets sitting here today and how that translates to our revenue guidance for 2016. We've broken it down by major end markets and geographies. As you can see by the variation of colors and symbols, our end markets are seeing a wide variation in trends. North America commercial HVAC and residential HVAC as well as European transport and commercial HVAC markets are generally positive, while global industrial markets are declining. We're forecasting transport markets in North America to be down low single digits. Our forecast for North America trailer volumes has not changed, and we expect the market to be down slightly for the year. This implies a decline in the second half after single-digit growth in the first half of the year. Asian HVAC markets are expected to be flat to down, and industrial markets in Asia remain under pressure. Golf car markets are slightly down offset by increases in the utility vehicle markets. All of our revenue growth forecast are shown on an organic basis. We're forecasting mid-single-digit growth in commercial HVAC in total; high single-digit growth in residential HVAC, which is essentially an all North America business for us; and a flat-to-small decline in transport globally. We expect compression-related products and other industrial equipment to be down high single digits. We expect Club Car to be up low single digits. Please go to Slide 15. Aggregating those market backdrops, we expect our organic revenues for the full year 2016 to be up 2% to 3% versus 2015, with foreign exchange presenting a headwind of about 1 percentage point. We expect Climate revenues to be up 4% to 5% organically. For Industrial, we expect organic revenues to be down 4% to 5%. For operating margins, we're excluding restructuring costs to get to adjusted margins. We expect adjusted operating margins in Climate to be between 14% and 14.5%. We expect adjusted Industrial margins to be between 10% and 11%. And for the enterprise, we expect adjusted operating margins of 11.5% to 12%. Please go to Slide 16. Transitioning to earnings. The estimated earnings per share range is $5.47 to $5.57, while the adjusted range is $4 to $4.10 compared to our previous guidance range of $3.95 to $4.10. The adjusted figures exclude restructuring and the Hussmann gain. Our full year guidance reflects a tax rate forecast of 22% to 23% and an average diluted share count of approximately 260 to 261 million shares. The tax rate indicates a 200 basis point improvement from the earlier guidance of 24% to 25%. For the third quarter of 2016, revenues are projected to increase by about 3% organically. We anticipate Climate revenues to grow in the mid-single digits for Q3 and Industrial to decline in the low single digits. Adjusted third quarter earnings per share are expected to be between $1.25 and $1.30, excluding restructuring charges of around $0.01. For the full year 2016, we have also increased our free cash flow forecast, now anticipating free cash flow to range between $1 billion and $1.1 billion, excluding restructuring charges and proceeds from the sale of Hussmann.

Okay. Great. Thank you, Sue, and let's go to Slide 17. So to conclude, we had an excellent quarter grounded in solid execution. I'm proud of the many people within Ingersoll Rand that continue to deliver for our customers and for our shareholders. I'm pleased with the progress and the momentum and the implementation of our operating system, and the growing depth and bench strength throughout the company that makes the operating systems come to life through continuous improvement. We're building a stronger, more valuable and more sustainable and less cyclical Ingersoll Rand than ever before. And it's exciting to me and leaders throughout the company to be part of that transformation and to help create a bright future with more individual development possibilities for all our people throughout the world. Results we reported this morning are a direct result of strategic work, the persistence, the tenacity of the talented people that represent the unique culture we're building. It is a strategic advantage and it's the toughest thing in any business for a competitor to copy. There are a few takeaways I want to point out to you as we head to the back half of the year and into 2017. First, the Industrial businesses are running effectively in a very tough market environment. The management team is aggressively taking and will continue to take the right actions to reduce the overall cost structure of the business. And it's committed to protecting the key product and service investments that will build long-term growth and margin expansion when the markets improve. Second, the transport market is performing as we expected. And as we said at the beginning of the year, we expect the first half results to be up and the back half of the year would be down. The management team has done an effective job anticipating and seeing around the corners and is proactively taking the actions to ensure strong margin performance continues. Third, commodity deflation has been a tailwind during the first half of the year, and it's going to moderate to neutral in the back half of the year. We have a long track record of managing the price material input equation very effectively and we're going to continue to do so going forward. And finally, let me say, we are proactively reviewing both prior restructuring considerations as well as new actions as our business, markets and even the input variables into our own models continue to evolve. Although we don't have any immediate additional restructuring actions to take or announce today, we won't hesitate to take additional prudent restructuring actions going forward. So with that, Sue and I will be happy to take your questions.

Before I ask my question, I just wanted to clarify, Sue, did you mention the tax rate 20, 23 is now a structural tax rate going forward?

Yes, it's 22% to 23%, and that's the ongoing rate.

Okay. Great. That's very clear. Mike, obviously, very strong booking orders for the North American commercial HVAC in North America, low teens. You mentioned a 25% number on the last call. I'm not sure we're comparing apples to apples here, but maybe just clarify that 25% as the low teens that you actually booked. And then maybe if you can just dig into the health of the light-commercial versus applied unitary markets?

Yes, Nigel, thanks for that question. Actually, I would expect 2 quarters of similar growth, 2 quarters of teens versus one 20-plus quarters. So I think that's intact. The pipeline, frankly, has never been healthier than it is right now. And it's healthy through all the institutional large project work. Commercial is maintaining some resiliency that we're seeing here. In unitary, at the light levels, still strong for us. So residential, all the way up through light commercial, still remains very strong for us across the board.

Okay, great. So there are no signs of weakness. Regarding the Climate margin outlook, you achieved 13.8% in the first half of the year. The lower end of your margin guidance for Climate suggests that margins may be flat in the second half, which appears quite pessimistic. Can you provide some context on why you anticipate an outlook of potentially 14% at that lower end?

So Nigel, let me start out and then Mike can add his comments as we go forward. So as I think about Climate in the back half of the year, you're going to have a couple of different dynamics. The first of which, as we talked about, was that direct material was going to moderate in terms of its deflationary environment. So let me talk about that for just a second. What we expect to see in the back half of the year is we expect to see that steel, particularly in the fourth quarter, is going to turn more inflationary than deflationary. So that's part of what's happening with the flatter margins. We're also going to continue to invest in the overall business in the back half of the year. Again, we've got some significant product launches, and we see this as an area that really sets us up for success. So it's really price, a little bit of mix that comes from us lapping the 14 SEER in residential and then investment in the business.

And Nigel, I'd just say, to me, the biggest number on the page is we're putting 50 basis points of margin back into investment. And it's a formula that's worked for us. Sets us up well for 2017. And we like what we're getting out of those investments.

Just on the Industrial margin guide for the second half. So it looks like you're looking at a margin of maybe 11%, 11.5% in the second half. The clean margin was 10.9% in Q2. So I thought maybe there'd be a bit more coming through to support margins from productivity or cost reduction? So I just wondered why maybe there wasn't a bit more urgency around getting the cost out, as it looks as if the sort of margin decline is going to be similar second half as first half?

I'm sorry, Julian. To start, I believe the key point here is that we are about 40% through an investment cycle, and there is no reason to halt that process. This will continue for the remainder of the year, which I consider vital. There is a significant initiative underway to reduce costs in the business. Much of this effort goes beyond what you might categorize as qualified restructuring; it includes various reductions and other containment actions being implemented. I am confident that we are managing the business effectively, ensuring that all avenues are explored while also safeguarding this essential investment pool for our future. I mention this as a specific example because it pertains to our product growth team, which has successfully launched a product in that area and is seeing excellent results. While the story for the third and fourth quarters may not be outstanding, we focus on the long-term vision rather than just the immediate quarters, and we hope investors recognize this. This is part of why we are seeing positive developments in our Climate business, maintaining high utilization through our combined manufacturing capabilities, and leveraging excellence across our compression-related sectors. All of this allows us to maintain our investment strategy, which is critical.

Very clear. My follow-up question is regarding the impact of input costs in the fourth quarter. The last data I have on the breakdown of cost of goods sold is from 2010 or 2011, which was when materials were a significant concern. Can you provide any updates on the COGS breakdown in relation to raw materials versus processed materials and components?

Sure. In terms of direct material spend for the company, it's about $6 billion a year. Breaking that down, the commodities we’re discussing account for roughly 10% to 12% of that total. Further analysis shows that steel is the largest component, with copper and aluminum following behind. The price pressure we anticipate in the latter half of the year is primarily related to steel, as copper and aluminum prices are remaining stable.

Mike, just thinking kind of bigger picture here, strategically. You guys are actually doing a really solid job, operationally. And I can't help but look at Lennox at 22x earnings, and Atlas Copco at 22x earnings, and just wonder if you're actually reevaluating the portfolio? I know you went through the exercise with Allegion, and the businesses that you retain are air-oriented businesses. But do you have any thought or response to that question or that idea?

Yes, Jeff. That's a great question, and I appreciate the chance to reflect on it. Looking back over the seven years I've been in this role, I remember when our Industrial sector was a standout performer, especially from 2009 to 2011 and even into 2013. We were able to expand margins quickly, which allowed us to make significant investments in our Trane, residential, and commercial businesses. That groundwork is reflected in the strong numbers we see today. Now, the situation has changed; back then, we lacked real commercial support, especially from the construction markets. Now, however, we have the opportunity to keep our factories well-utilized and ensure that our technical professionals remain heavily involved in product development. This positions us well for the future. When the commercial HVAC market eventually cools down and institutional support wanes, we hope to have a robust, updated, energy-efficient, and reliable portfolio ready, especially in compression technologies. We plan to leverage that just as we did between 2009 and 2011, when we experienced a growth of seven full points. We are well-positioned regarding our fixed costs. Our focus in the market is on the larger machines, specifically the 250- to 400-horsepower centrifugal air compressors, where we currently hold a leading position. We have limited involvement in the vacuum and blower sector, despite its growth potential. Our product portfolio and market position in these larger machines are facing challenges right now. However, we’re committed to maintaining our direction and not making rash decisions. Consequently, we will continue our investments in product development and machining, dedicating $50 million to machining during this downturn. We aim to improve our productivity when we recover, with hopes of exceeding a 7-point margin upon our return.

Yes, I had a heroic buyback in 2009. Thanks for that perspective. Also then just on the balance sheet, Mike...

Jeff, just before we do that. Incremental margins every single year have been in the top quartile. Organic growth rates almost every single year have been at the top quartile. We've done that with elements of the portfolio firing and not firing at various points in time. And I just have to believe that there's value in that, and there's industrial logic around what we're doing around the sustainability and energy efficiency fronts of the business. So go ahead.

Yes, I know, I agree. I mean your performance has been great, and just you're not getting fully paid for it. The balance sheet, what is the plan for the year end? Sue gave us the kind of the generalized color. But with the Hussmann proceeds and the strong cash flow, would you be opportunistically looking to step in share repurchases here? I can't imagine the M&A pipeline is that active but perhaps it is.

So Jeff, let me take a shot at that, and then I'm going to let Mike jump in. But I'm going to kind of use some of the same passion that Mike had in his comments on the multiples and what we've built at Ingersoll Rand. From a perspective of our cash generation and then our ensuing capital allocation, we're really trying to create longer-term shareholder value with the cash that we're generating. And so what we've seen that has been really successful for us is investing in our products and investing in areas like energy efficiency and sustainability. Those are proven for us in terms of building our growth excellence. If we look at Operational Excellence, all of the work that we've done and invested in the company, whether it's in our factories or in our overall processes with the business operating system, all of that has shown to be something that has worked very well for us. So our preference, as we think about capital allocation and your question, is to really invest and grow the company. So to be more specific, then, in terms of what that means, it means I want to continue to invest. It means I want to continue to do all of those things. It means we want to look at the M&A pipeline. But what we have is an opportunity where we can be patient, we can wait for the right opportunity and not just take the cash that we're generating and run out and buy something. So we're really, really thinking about investments. We're thinking about M&A. Dividends are extremely important to us. We understand that. And we're going to continue to have dividends that are in line with our peer payout ratios, and we'll also be opportunistic about share repurchase. I don't want to take that completely off the table. But if I set our preference up, it's going to be to build longer-term value through investments in the business and acquisitions.

Yes, I agree, Jeff, with Sue's comments completely, obviously. But I would tell you that the competitive dividend is a given, and the fact that we're controlling dilution of the share count is a given. Just we don't want dilute shareholders through that, so that's a given. The optionality beyond that, we want to be really smart allocators of capital. And we want to have our eyes wide open on how we do that. When you get big dislocations in the share price, we want to be opportunistic, and we were in the first quarter between $48 and $51 a share. I mean, clearly, that was a good idea. And we've been opportunistic when we saw value in long-term creation through acquisitions. And so we'll continue to do that. Now all that being said, I think we have less than $1 billion in cash, so that's not a whole lot of cash we are talking about for a company our size to be walking around with.

Welcome Zac.

Thank you.

My first question is about the investment you’re making in Industrial. How much of it is intended to catch up versus being a genuine investment for future growth? Additionally, how do you balance this with the understanding that we are about 7 to 8 years into the economic recovery and might remain in a lower growth environment for a while?

Joe, the efficiencies from the product launch, specifically the 40% of the portfolio I mentioned, are showing a range of 9% to 13% greater efficiency compared to competitors in the market. This is how we approach marketing by emphasizing value and total cost of ownership. As a result, that segment is growing in the high-teens, with bookings nearing 30%. We have no intention of simply catching up to others in the market. Everything we have done is aimed at surpassing the efficiencies and reliability currently available. If you examine the Trane portfolio, you will notice that in every launch, our products not only outperform existing market options but also utilize refrigerants that exceed the HFC phase-out standards. We are not simply meeting the status quo; we are advancing beyond it. Our strategic analytics within our business operating system are effectively identifying areas for targeted growth. We have established clear strategic growth programs, complete with the necessary resources, talent, and investments, ensuring our commitment to these initiatives, which accounts for over 80% of our growth coming from our focus areas. This progress is not a result of following others.

Got it. That makes sense. Can you provide some insight on the investments in the Industrial sector?

Well, I'm not sure what specific investments you're referring to in the Industrial sector, Joe.

I understand that you are asking about the investments in Industrial, especially considering the current weaker growth environment and the potential for it to continue. I'm trying to grasp whether there is an opportunity for the Industrial sector to catch up, and if your portfolio is better positioned compared to your competitors. Any insights on the competitive landscape regarding your investments would be helpful.

The investments we are making focus on areas where we are not currently leading. Any market where we do not have a strong presence is a target for us. While we will maintain our competitive edge in the 250 to 400 horsepower segment, we are actively pursuing growth opportunities in other areas. I prefer not to provide specifics because we aim to execute effectively and improve margins rather than disclose our strategies competitively. Our approach has always been to ensure that our strategic analytics align properly and that our investments are targeted. Collaboration among our product growth teams, including engineering, operations, and product management, to focus on one or two key priorities for boosting market share and margins within specific product or service lines has proven successful for us, and we will continue this strategy.

And so the other thing that I would add, Mike, just as a practical matter, Joe, for what you're talking about is the investments that are ongoing in Industrial are going to be in the same general areas as you would expect. They're going to be in new products. They're going to be in Operational Excellence, so improving our operating results. And they also include some channel investments, particularly in the compression technologies business. So all the areas you might expect.

Got you. That makes sense. And just one real quick one for you, Sue. On just the price cost breakdown this quarter, how much did material deflation versus price contribute?

In the first quarter, the contribution from price and direct material deflation was roughly equal. In the second quarter, there was a greater emphasis on direct material deflation, shifting to about 60% deflation and 40% price. We achieved positive pricing in both segments. When we provided guidance for the second quarter, we initially projected 110 basis points, but it ended up at 120, aligning with our expectations for the quarter. To reiterate my earlier point from Q1, we experienced no breakage, resulting in a solid outcome.

Yes, Joe, I actually want to take you back to the Industrial question for a second. I just had one more comment here. I made a comment about the strength of the management team, which ultimately I think is what really investors need to believe in and buy. And I look at our Industrial segment management team, and I can tell you that the top 5 to 10 executives running that part of the business co-architected the entire business operating system with me since it began. I couldn't have higher confidence in our ability to win as the markets recover. So I want to make sure that, that point is really clear. It's a very strong management team paying attention to the detail in the business.

It appears that you're successfully gaining profitable market share in the Climate sector, but what is happening in the VRF area? Additionally, on the Industrial side, Atlas Copco Compressor Technique saw a 1% increase in orders during the quarter. I understand they have a different product mix, including vacuum systems and a somewhat smaller presence in North America. Could that account for the situation, or is there something else we should also consider?

Yes, looking at Atlas Copco's business, they will excel in oil-free rotary products, although in a smaller segment compared to our larger centrifugal machines. We have strong oil-free products and are expanding that area as well. However, most of Atlas Copco's focus is on vacuum and blowers, which are still in a growing market. It's important to consider the industries that utilize oil-free technology or vacuum and blowers, as those industries are also experiencing growth, unlike the heavier industries typically served by larger centrifugal machines. We conduct a thorough comparison using all available public information on our competitors to understand the competitive landscape better. We are realistic about the opportunities for self-improvement, which currently involves growing our service businesses, where we are making good progress. Additionally, we're refreshing and developing our portfolio of smaller machines, which will be our focus moving forward.

Okay. And on the VRF side?

VRF is performing exceptionally well and is growing at a faster rate than the core unitary business. We maintain a very high market share and are not experiencing any slowdown in that area.

Okay. Following up on your earlier comments about the balance sheet, Mike, you've mentioned in the past that there are opportunities for consolidation within the overall HVAC market. How are you considering that, given the industry's dynamics moving forward? Do you believe there is still potential for that?

I believe there are significant opportunities. Looking at our acquisition of Cameron's compressor business, we achieved synergies of 15% in the first year and plan to increase that this year. I see strong synergies and larger, more complex deals on the horizon.

What is happening in the Industrial sector? It seems that previously, it was considered a high-quality business with strong margins, but now it feels like we're consistently getting further into a difficult situation. You mentioned the end markets; could you remind us about the proportion of oil and gas, including Cameron? Additionally, how much of the business is related to or around oil and gas? Are we possibly misclassifying some of the end markets? Do you have more exposure to these markets than we initially expected?

Yes, Steve, I'll save the oil and gas math for somebody at the end here. But if you look at the biggest market we're in on big machines. And I used 250- to 400-horsepowers as being a big machine down 20%. Actually, as you go up between 250 and 400 and past 400, those growth rates start to look like minus 50%, okay, from where they were. These are the most capital-intensive sort of factories we have. And that certainly, when we have those kinds of volume drops, really adversely affects our mix. So you look at volume alone contributing 3 points of negativity on the bridge, you can see what volume does. And as a proof point, again, go back and look at '09 through '11, look what happened when volume came in, after we had been effectively restructuring the footprint there, and that's where that 7 points came from. So we're heavily leveraged toward that any way you slice it, and that's the main reason for it. Now on the oil and gas side?

Yes, oil and gas is expected to represent a low single-digit percentage. This is partly due to the absence of large projects, but it's also indicative of the broader situation, as many other projects are not progressing and are being categorized under oil and gas. To provide some context based on what I mentioned about Industrial early in 2016, I had indicated that Club Car constituted around 20% of the business and was projected to grow in the low to mid-single digits. The aftermarket was about 30% of the Industrial segment, also anticipated to be up by low single digits. I noted that the larger machines were expected to decline by over 20%, whereas some smaller rotary and small air products were expected to see slight growth for the year. Other sectors, like Material Handling and tools, were projected to decrease by mid-single digits. Now, reflecting on what we've observed in 2016 after two quarters: Club Car remains in the same position, growing in the mid-single digits and on track. The aftermarket segment of Industrial is still experiencing growth, providing a solid foundation for roughly 50% of the business. However, when I mentioned the large machines being down 20%, as Mike noted, they are now down 50%, which is much worse than I expected. Additionally, some of the smaller equipment is under more pressure than I anticipated. Instead of seeing a slight increase, it's now projected to decline. There are many dynamics at play in the Industrial business. To connect this back to your question about oil and gas and projects, we are experiencing significant derivative effects in most of our industrial sectors, where large projects are simply not occurring, and the ones that are happening are much more competitive.

Yes, it's a bit of a Yogi Berra euphemism. But the business will turn when our customers start spending money on these larger plants. And so that needs to happen.

Yes, I'm not aware of anything similar in my sector. I'm not blaming you at all; it is what it is. If you mentioned a 50% decline, we could point to oil and gas capital expenditures and that would make sense. Currently, the market is recognizing a 50% increase in spending related to oil and gas for the next year in some cases. However, I'm unsure what else in the economy, apart from oil and gas, is experiencing year-on-year declines of 50%. Even large gas turbines and big ticket items are not facing 50% declines, maybe around 20%. That's the basis of my question, if you understand what I mean.

Yes, there's a spot between sort of small plants and energy production that is a large plant. Steel would be a great example of that. Marine, these are heavy industries that use large machines for air, and that's really kind of where we're suffering on that.

Yes, that makes a ton of sense then. If it's that derivative type of stuff, that makes a ton of sense. One last question, Middle East you said was down. How much was the Middle East down in Commercial HVAC in the quarter?

It was down about 14%.

Yes. And Steve, I'm going to add one point. Material Handling, if you go back and bridge over a multiyear period, it was 2, 2.5 points of Op margin that went away as that business went down 90% or so for us, okay? So you don't want to look at Industrial and kind of hang it all back on a comparison to Atlas Copco on compressors. You want to make sure you understand there's a couple of points of margin there, about a point in tools. Currency is a hit and then you got the volume impact that we talked about on the bridge.

I guess I won't belabor the Industrial business. On transportation, could you just talk as to what you saw in the quarter that your view has changed? Because before you were sort of saying how the North American truck cycle was decoupled from the refurb market? And it seems like you've changed your view?

Andrew, the subtlety is moving inside that, but the view has always been you're going to see a pullback with American trailer as much as 15% and flat TK. And the mix is changing slightly within that, but it's really what's happening for the full year.

And can we talk about cadence of transportation weakening into the second half, third quarter versus fourth quarter declining, any preliminary thoughts on 2017?

Q3 is expected to be weak due to last year's strong performance, which was our highest comparison. The comparisons will ease slightly in the fourth quarter. However, if we look at the first half of the year, it balances out to being flat with no significant changes. The marine container segment is weak, and most of the changes are coming from the North American truck and trailer market, along with some decline in Class 8 sleeper production affecting APUs.

So Mike, just you changed your guidance in Climate from 4% to 6%, to 4% to 5%, but just following up on Andrew's question, is the difference really APUs? Or is it marine? Or is it Middle East? Or is it a combination of the 3?

Middle East is much weaker than we anticipated at the beginning of the year. And as you could imagine, it's a large HVAC business. And so the drag on the Middle East was fairly material. We're seeing some growth in China. That growth was really around shipping product that was booked, but we really haven't seen the pickup in China per se. If you look at China nonresidential construction, it's still a negative, but for the past 6 or 7 months, it's been trending up. I think it's gone from negative 17% up to negative 2%, but it hasn't crossed over. We really would have thought at this point, we would've seen more pickup. The nice thing in China, buildings are built in about half the speed that we see in other parts of the world, and our cycle times for delivery can be half of what they are in other parts of the world as well. So if we did see a China recovery on the HVAC side, you need to see that, say, within a 6-month period, not a 12-month period. But as you get into July and you're not really seeing the bookings here, it's just a way of really derisking the forecast. And really, that derisking is a theme coming into the industrial portfolio too. At this point, if we haven't seen bookings on large machines or bookings on midsize, even rotary machines at this point in time, the reality is you just call it lower, and it's what we've done. And so we hope we've got to the bottom of this thing.

Mike, that's helpful. Looking at European transport refrigeration in general and FRIGOBLOCK in particular, it appears to be holding up quite well. Have you noticed any changes since the Brexit announcement? What is the outlook for that specific business?

We haven't seen much change in relation to Brexit. Like many companies, there is a lot of discussion, but not significant change. Our U.K. business is relatively small overall. The main concern is the potential impact on the region's GDP. However, our business continues to perform well and is stable. We do not anticipate any significant changes due to Brexit or other market factors in the next few quarters.

I'd like to thank everyone for joining today's call. We truly appreciate your participation. And I look forward to meeting all of you in the future and reconnecting with many of you that I've worked with before. Thank you very much, and we'll be in touch soon.