Trane Technologies plc (TT) — Q4 2016 Earnings Call Transcript

Thanks, operator. Good morning, and thank you for joining us for Ingersoll Rand's Fourth Quarter and Fiscal Year 2016 Earnings Conference Call. This call is also being webcast on our website at ingersollrand.com, where you'll find the accompanying presentation. We are also recording and archiving this call on our website. 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. This 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; and Sue Carter, Senior Vice President and CFO. With that, please go to Slide 3, and I'll turn the call over to Mike.

Thanks, Zac, and thank you to everyone for joining us today. 2016 was another great year for Ingersoll Rand, a record year, where we hit the mark in all the critical financial metrics. We'll get into some more detail on that in just a minute. I'd like to start this morning by talking about our business strategy and how that has enabled us to deliver another year of top-tier performance in 2016. Then Sue will discuss performance in the fourth quarter, we'll give some color on our 2017 markets and guidance and I'll close with addressing topics we know are on the minds of investors before Sue and I take your questions. As I said, 2016 was a record year for Ingersoll Rand. It follows a multiyear pattern of consistently strong operating and financial performance driven by our strategic framework of sustained growth, operational excellence, excellent cash flow conversion and a commitment to our winning culture. Our strategic objective is to drive profitable growth through leadership positions in growing markets that are durable because they address a global imperative to dramatically reduce energy demand and resource constraints in buildings, homes, industrial and transport markets around the world. Turning to Slide 4. In 2016, we extended our multiyear record of top-quartile performance on organic revenue growth, incremental margins, earnings growth, free cash flow and total shareholder return. We delivered free cash flow of approximately $1.3 billion and 3% organic revenue growth and operating margin expansion of 60 basis points to 11.6%. Free cash flow was 121% of adjusted net income and more than $5 per outstanding share. Adjusted operating margin leverage was 44%. Adjusted continuing EPS of $4.13 was up 11%, demonstrating the strong leverage of the business. We also retained a strong balance sheet with good optionality, while at the same time, returning a significant cash to shareholders, paying roughly $350 million in dividends and executing $250 million in share buybacks. We continued our long history of raising our corporate dividend. And in 2016, we raised our quarterly dividend by approximately 40%, through 2 increases from $0.29 per share to $0.40 per share. We are now at $1.60 annualized per share. I said throughout 2016 that rigorous execution would serve us well to drive leverage in the P&L and deliver strong cash flow and margin expansion, even in a low growth environment. We followed our business operating system to capture growth, improve cost and drive productivity, all of which translated into 60 basis points of margin expansion. 2016 growth was led by North American Commercial and Residential HVAC. The teams here are doing a phenomenal job of share gain and margin expansion, and we anticipate this momentum to continue into 2017. While North America HVAC led the growth, we made deliberate choices in the selection of growth programs across the whole portfolio, and then we operationally led those programs to product growth teams. We see breakout results with this strategy. The average growth rate for our model product growth teams was more than twice our overall company average growth rate for the year. We also drove significant innovation, launching more than 80 new products and services in 2016, with introductions happening in nearly every business and region. We realized benefits of new product and technology investments as the offerings supported our 2016 growth, share gains and margin expansion. I emphasize this to demonstrate our commitment to organic long-term strategic investment in innovation to remain ahead of our customers' expectations, the competition and the regulatory environment. And heading into 2017, we haven't slowed down with our focus on product growth teams. A couple of weeks ago, we launched our personal transportation vehicle, called Onward, for the consumer market, resulting in a 10% order increase above our initial launch plan. Getting back to 2016, we also continued our multiyear trend of service parts and solutions growth in both segments. HVAC aftermarket outpaced equipment growth annually with high single-digit growth ex foreign exchange. In Compression Technologies, we also realized 3% growth in our aftermarket business. This consistent performance against our strategy to deliver higher service penetration across our segments helps build strong relationships with customers and a more resilient business portfolio. As anticipated, we continue to see more and more growth within our portfolio stemming from smart, wireless and digitally connected solutions in 2016 that are more reliable, more cost-effective and energy-efficient. Each one of our business units is executing a digital strategy, and we are a recognized leader in this area. Our Energy Services and Controls business, for example, is actively servicing 6,500 connected buildings, and we are one of the top providers in this space. Anticipated growth rate here is approximately 30% for 2017. The diversity of our business portfolio helps to mitigate cyclicality in our end markets, which has enabled us to sustain strong performance over time. Growth teams dedicated to our lines of business help us create real value using a wide range of technologies and innovation. Our objective is to take advantage of growth where the market is in an upswing and to build on our competitiveness in difficult markets. Moving to Slide 5. The measure of our success is represented by our financial results and total return to our shareholders. Slide 5 demonstrates our consistent performance over time and the metrics that matter to our shareholders, whether it's revenue growth, adjusted EPS growth, cash flow, ROIC or adjusted operating margin improvement. 2016 was another excellent year that extends this track record, a record year and one we're proud of. Now I'd like to turn the call over to Sue to comment on the fourth quarter.

Thank you, Mike. Please go to Slide #6. I'd like to begin with a summary of main points to take away from today's call. As Mike discussed, 2016 was a very strong year for Ingersoll Rand and marked another year of continued top-tier performance on free cash flow, organic revenue growth, operating margin improvement and earnings per share growth. While we recognize the fourth quarter contained more one-offs and noise than any of us would have liked and distorted our fourth quarter earnings report, fundamentally, it was still a strong quarter for the company relative to our core businesses. There shouldn't be any significant read-through to our go-forward results. Free cash flow was more than $350 million in the quarter, bringing our 2016 free cash flow to $1.35 billion, which is up 37% versus 2015 or more than 120% of our adjusted net income. From a segment perspective, the combined Climate and Industrial segments adjusted operating income results were solid and a bit better than our expectations for the quarter. Our bookings performance was very strong, with Commercial and Residential HVAC leading the way with both at low-teens growth. Residential revenues increased low-teens. Operating margins also expanded in both businesses. We were pleased with our Industrial business performance, which showed slow but steady adjusted margin improvement after hitting a low in the first quarter. We continue to take additional actions on operational excellence initiatives, increased commercial focus on aftermarket parts and service offerings and took additional cost-reduction activities to improve operating results going forward. EPS in the quarter was negatively impacted by discrete items in G&A, negative other operating income and taxes, as I'll discuss on the next slide. Please go to Slide 7. We've provided a bridge from the fourth quarter guidance range we provided on our Q3 earnings call to our actual Q4 results. As I noted earlier, our segment operating performance was in line with our expectations. Actually, about $0.01 better. We incurred higher-than-expected corporate costs, primarily due to stock-based and other incentive-based compensation given our strong cash flow performance and stock performance in 2016 and from increased information technology infrastructure and security expenditures. These items combined for a negative impact of about $0.04. We expect our corporate G&A expenses to come back down to a more normalized run rate of about $60 million per quarter in 2017. We also incurred higher-than-expected nonoperating cost as a result of foreign exchange losses related to the balance sheet given the strengthening of the U.S. dollar, which had a noncash impact of $0.01. Lastly, we had a higher-than-expected mix of earnings from high tax jurisdictions, which impacted us by about $0.03. While this was a significant negative in the fourth quarter, our adjusted tax rate for the year of 21.4% was on the low side of the 21% to 22% range we updated on our second quarter call. I feel good about the effective tax rate, and more importantly, we expect the rate to remain in the 21% to 22% range for 2017 as well. Please go to Slide #8. Top line organic growth of 2% was solid, highlighted by our North America HVAC businesses. Operating margins and adjusted operating income plus depreciation and amortization were both down, primarily driven by Industrial segment margin decline and the higher-than-expected cost we previously discussed. Please go to Slide 9. Organic orders were very strong in the fourth quarter, up 7%, led by our Climate segment and partially offset by modest declines in our Industrial segment. Climate bookings were up in every region and business globally and up 10% overall. Organic Commercial HVAC bookings were up low-teens in equipment, with strong results from both unitary and applied products. We also continue to drive excellent growth in service, controls and contracting with low-teens growth in the quarter. Residential bookings continue to be exceptional, up low-teens. Organic transport orders were up mid-single digits, primarily driven by growth in Europe, partially offset by declines in marine equipment and auxiliary power units. We also had mid-single-digit increase in North America trailer orders in the fourth quarter. On balance, the Industrial businesses bookings were flat to down slightly in the quarter, reflecting some stabilization in end markets. Please go to Slide #10. This slide provides a directional view of our segment revenue performance by region. In our Climate segment, revenue was strong in North America, flat in Asia and down in Europe, Middle East and Africa and Latin America. In our Industrial segment, overall performance was down low single-digits, primarily due to difficult comparisons with 2015 on large air compressor shipments in North America and Europe, Middle East and Africa. Revenues improved in Latin America and Asia. Overall, North America revenues were up mid-single digits and international revenues were down mid-single digits, netting a positive 2% organic revenue growth rate for the enterprise. Please go to Slide #11. Q4 operating margin declined 50 basis points, primarily due to headwinds resulting from material inflation in steel and higher corporate cost in the quarter. On a year-over-year basis, lower Industrial margins also contributed to the decline. Volume and mix was positive in the quarter. Please go to Slide #12. Overall Climate performance was strong in the quarter, with organic revenues up 4% and adjusted operating margins up 70 basis points to 13.6%. Strong revenue growth in both commercial and residential HVAC was partially offset by Transport revenues, which were down mid-single digits in the quarter, primarily due to weak auxiliary power unit and marine markets, partially offset by growth in aftermarket and in Asia. Climate operating margins expanded 70 basis points year-over-year. Favorable volume, mix and productivity was partially offset by material inflation headwinds and continued investments in the business. Please go to Slide 13. Fourth quarter Industrial margins declined by 220 basis points compared with 2015 while organic revenues declined 3%. Revenues were down mid-single digits in compressors, with growth in aftermarket. Other Industrial products were down by high single-digits, with material handling showing the largest decline, more than 50% owing to its significant oil and gas exposure. Small electric vehicles were up slightly in the quarter from growth in golf. Industrial's operating margin of 10.5% was down 220 basis points versus the prior year but in line or slightly ahead of our expectations for the quarter. Looking forward, we expect margins to improve in 2017, given ongoing margin improvement actions, although we do expect some quarterly variability due to cyclicality. Please go to Slide 14. Excellent full year 2016 free cash flow of $1.3 billion improved 37% versus the prior year and was over 120% of net income. Strong operating income and working capital improvement were the primary drivers of the improvement. For the quarter, working capital as a percentage of revenue was 3.4% versus our 2016 goal of 4% and improved 80 basis points versus 2015. We have a proud history returning cash to shareholders. Since 2011, our free cash flow as a percentage of net income has averaged 100%. Over the same time frame, we've returned more than $6.5 billion in cash to shareholders through dividends of $1.5 billion and share buybacks of $5.1 billion. Please go to Slide 15. Our strong cash performance in 2016 will enable us to, one, invest in our business as our number one priority. These include investments in innovation and in strategic growth programs, as Mike outlined earlier. In addition to the core strategic investments, we're also investing in long-term growth through innovative and differentiated products in areas such as wireless, controls for building as a resource, intelligent monitoring and self-healing systems, just to name a few. Two, we've paid an annual dividend for 106 years and have consistently raised this dividend over time. Over the past 5 years, we've raised our annual dividend at a 20% compound annual growth rate. In 2016, we raised our annualized dividend from $1.16 to $1.60 per share or nearly 40%. Three, we also spent $250 million repurchasing shares sufficient to offset dilution. Four, additionally, in 2016, we continued to develop and vet a pipeline of potential acquisition targets. And five, lastly, in 2016, we strengthened our balance sheet, which provides stability and optionality as our markets evolve. We also maintain a BBB credit rating, which, at this time, we believe is appropriate for the company. We will continue to create long-term value for our shareholders through a dynamic capital allocation strategy as we have consistently done for years. And with that, I will turn it back to Mike to discuss our market outlook as we begin our guidance conversation.

Thanks, Sue. And if you move to Slide 17, we'll begin our guidance conversation with some color around our end markets. As always, our intention is to give you our best view as we know it today and how that translates to our revenue outlook for 2017. We've broken it down by major end markets and geographies. We expect North American Commercial HVAC and Residential HVAC to show continuing growth. In North America, 50% of our commercial business is parts, service and controls, and we are seeing strong demand in all these areas as well as for upgrades and energy retrofits. Residential replacement, which makes up approximately 80% of the total market, closed the year on a strong note, and we expect to see continuing growth next year in both replacement and new construction. Commercial HVAC markets in EMEA and Asia are expected to be flat. We expect Latin America to be up mid- to high-single digit. Transport markets in the Americas will be down from lower volumes for trailers and auxiliary power units, partially offset by trucks. North American trailer volumes are expected to decline by low-teens. Transport Europe is expected to be up based on truck and trailer sales and a bottoming of the marine container market. Asia Pacific was up high-teens last year, and we expect continued growth in 2017 on its smaller base. Global Industrial markets are generally improving, but still remain soft. We believe we are seeing a bottoming trend in our general industrial markets in the U.S. and the Eurozone as PMIs have improved over the last several months. We have also seen some order improvement in our short-cycle Industrial businesses. While this is a positive, the modest rise in Industrial production suggests a gradual recovery, with bumps along the way. Industrial markets in Asia remain under pressure due to excess capacity in many key industries. The large engineered compressor market is expected to show signs of improvement due to stabilizing activity in energy markets and heavy industry. While expecting year-over-year orders to be up, revenue will decline due to depressed 2016 order levels and the average lead time of 12 to 18 months for this type of product. Excluding these longer lead time products, we expect our Industrial segment to be flat to slightly up. Golf and utility vehicle markets are generally flat to slightly up across all regions. Golf is expected to be flat, and we expect to see some growth in our consumer and utility vehicle markets. All of the growth forecasts shown are on an organic basis. We are forecasting mid-single-digit growth in commercial HVAC in total, mid-single-digit growth in residential HVAC, which is essentially North American business for us, revenues down low single-digits in Transport. We expect Compression Technologies and Industrial products, which includes our power tools, material handling and Fluid Management businesses, to be down low single-digits. And we expect Club Car to be up low single-digits. With that overview as a backdrop, we'll move into 2017 guidance. Before Sue takes you through guidance, I know some of you know that we recently completed in-depth interviews with the investment community to better understand how Ingersoll Rand is perceived and what we might do better to improve in our communications. We just received the results, and we'll be incorporating changes that reflect investor feedback going forward. Thank you to all of you who participated. One of the changes highlighted in the feedback was investor preference for the timing of company guidance. Overwhelmingly, investors said they had a preference for annual guidance with quarterly updates versus quarterly guidance. We have adopted this beginning with the annual guidance for 2017. Annual guidance is also much more aligned with the way in which we make decisions and manage the business internally, with a focus on building a better business over the long term. For those of you who prefer quarterly guidance, we'll get through the transition together and make sure it goes as smoothly as it can. And now I'll turn it over to Sue for specifics on guidance.

Thanks, Mike. Please go to Slide 18. Moving on to our guidance, we expect total organic revenues to be up approximately 3% in 2017. We expect the Climate segment to continue to show good growth of approximately 4% organic. For the Industrial segment, we expect the markets overall to be pretty flat, but for our organic revenues to be down slightly given the high volume of large compressors we shipped out of backlog in 2016, which will make for tougher compares in 2017. The difference between our organic and reported revenue contemplates about 1 percentage point of negative foreign exchange from a strengthening U.S. dollar outlook. For the enterprise, we expect adjusted operating margins of between 12.2% and 12.6%. We expect adjusted operating margins for the Climate segment to be in the range of 14.5% to 15% and in the range of 11% to 12% for the Industrial segment. Please go to Slide 19. We expect continuing adjusted earnings per share for 2017 to be in the range of $4.30 to $4.50, excluding about $0.15 of restructuring. The company also provides the following guidance. Share count is expected to be approximately 262 million shares. Target free cash flow is 100% of net income. The tax rate is expected to be between 21% and 22%. Corporate, general and administrative expenses are expected to be approximately $240 million. And capital expenditures are expected to be approximately $250 million. Please go to Slide 20. Relative to the company's plans for capital allocation, investing in the business is our highest priority, so we continue to make investments in innovation and growth in things like wireless and digital connected capabilities, productivity, sustainability and in our employees, just to name a few areas. Paying a highly competitive dividend is also a key priority for us. And based on our most recent dividend raise last October to $1.60 per share, we expect to spend approximately $420 million on dividends in 2017. In 2017, we're also targeting spending approximately $1.5 billion between a combination of share buybacks and acquisitions. Maintaining a strong balance sheet also remains a priority and provides us optionality as our markets continue to evolve. Let's go to Slide 21. And now I'd like to turn the call back over to Mike to discuss a few of the key topics we know are on the minds of investors as we enter 2017.

Thanks, Sue. The first topic discussed is our U.S. manufacturing base. I think you're all aware we operate on a region of use philosophy. We localize manufacturing in the supply chain to help us achieve greater speed to market and implement local product preferences. 95% of Ingersoll Rand products sold in the U.S. are manufactured in the U.S. Regarding components, we are likely less exposed as compared to other diversified industrials because of our focus on lean, and in particular, cycle time reduction. We've actually, through the years, been willing to sacrifice some price for faster delivery, meaning the source is coming from within the U.S. I think this issue is a bigger issue for companies that are importing finished goods into the U.S. such as consumer products or electronic companies. We are definitely a net exporter. The second topic is around the U.S. corporate tax rate. As you know, approximately 65% of our revenues are derived from the U.S. And therefore, we pay a significant amount of U.S. corporate taxes. If there is a reduction in the U.S. corporate tax rate, we would expect to benefit from it. Turning to Slide 22. I know we'll receive questions on the status of Industrial. Fourth quarter was above the guidance we gave in revenue and operating margin. We saw growth in several vertical markets, including food, pharma and tech as well as with our compressor aftermarket business, which was up 3%, as I mentioned earlier. However, we continue to see soft markets in large compressors and in the energy markets. We have seen some bottoming with orders for our shorter-cycle businesses such as Power Tools and Fluid Management, both up in the fourth quarter. As I indicated earlier, we expect the industrial markets to stabilize in 2017, although we cannot declare a definitive turning point. Excluding large compressors, we expect Industrial to be flat to slightly up, and we do expect to realize margin expansion through our operational excellence initiatives, new product launches, restructuring actions and ongoing cost reductions. Covering our transport business, you'll recall last year, we had a better-than-anticipated first half, a decline in activity in the second half, as we expected. For 2017 overall, we expect Thermo King revenues to be down low single-digits year-over-year. The North American trailer industry is expected to be down low teens year-over-year. We're also expecting a continuation for a relatively soft market for auxiliary power units and marine containers. Those declines will be partially offset by gains in Europe, Asia and aftermarket revenues. Through restructuring and efficiency, we would expect only a minor erosion of record 2016 operating margins. Moving to Slide 23, I'll touch on currency as a headwind for us in 2017. About 35% or $4.8 billion of our revenues are outside of the U.S. Our 2017 forecast has built in the continuing strength of the U.S. dollar, which will impact us most notably in the euro and Asian currencies. Overall, we expect a 1% drag on our revenues from currency translation, which will have about $0.10 negative impact on our EPS. And finally, we know material inflation is top-of-mind. We have 10 basis points positive price, covering material inflation in our guidance. And of course, we're working to increase that even further. We've been through various cycles and have a strong history of capturing price to material inflation. This long track record of managing price demonstrates to shareholders the discipline that exists with our people, systems and processes. So in closing, on Slide 24, we built a stronger, more valuable and less cyclical Ingersoll Rand. I'm proud of our employees who delivered a record 2016 performance that makes us a more sustainable company in every way. I am confident in our management team to execute our 2017 plan. We will maximize growth and focus on productivity and cost where markets are not accelerating. Our Commercial and Residential HVAC businesses are strong and focused on growth areas with equipment, controls and service. Our Transport Refrigeration business is diverse and agile and will execute their strategy as they typically do. Our Industrial businesses are focused on margin expansion as markets stabilize. As a result, I'm confident we'll continue to deliver top-tier financial performance. And with that, Sue and I will now be happy to take your questions.

Mike or maybe Sue, on the free cash flow, just remind us why it was so particularly strong in '16. I mean, the working capital performance was great. It looks like CapEx was a little bit lower; you're bringing that up. Just maybe refresh us on the dynamics of why you see that still being strong in '17 but not quite the version of '16.

That was a great question, Shannon. Free cash flow showed significant strength in 2016 because we concentrated on the fundamental aspects of our operations. Our goal was to ensure that our operating income effectively translated into cash flow. We paid close attention to accounts receivable, aligning our terms for customers with those of our suppliers. We actively addressed disputes and engaged with customers who had overdue accounts. We also collaborated with our suppliers regarding accounts payable terms and improved our inventory processes within our business operating system. Our primary focus was to ensure that operating income flowed through to cash flow while maintaining sustainable working capital levels. We did not restrict our spending on capital expenditures; rather, we encouraged good investments as part of the business strategy. As a result, we utilized free cash flow effectively in 2016, achieving excellent outcomes. Additionally, the free cash flow was consistent throughout the year, rather than being uneven. Overall, everything aligned well for us in 2016.

Sue won't say this, but I'll say it. She did a great job and her team training the organization on something we had fun with, called 'in the know on cash flow.' We had everybody in the organization go through that with the purpose to explain that everybody in the company has got something to do with cash flow. And people got excited about that story. It's really kind of pushing through. And I think that level of engagement is a factor. Somewhere in there, it made a big difference around people really exceeding this.

And then, Mike, maybe on the strength of those Climate bookings. I mean, up 10% organic. It looks like you're gaining share and you made a lot of new product investments. When you look across either the product type of applied unitary or the regions, any particular area that you feel you're particularly well positioned in terms of share gain?

Shannon, it was impressive because it was seen globally and across different unitary flag controls and services. There was no area of weakness anywhere in the world, which is reassuring to us. This broad-based performance gave us confidence in our growth expectations for the year, and we anticipate continued good growth into 2017.

Great teaser, by the way. I appreciate all the extra details in the slides. I wanted to return to Shannon's question about growth. It seems like you have gained market share across the board. A common question that arises is how sustainable this trend is. Could you touch on what factors are contributing to this growth, particularly in commercial HVAC? Additionally, it feels like you are trailing your major competitor in compression; could you address that as well, Mike?

Yes. First, I would say, Nigel, that you have to go back and realize that it's been sustained investments over time and product launches have been occurring at a high rate for some time. I think we've got the best channel in the world in terms of the people out there that are systems experts capable of bringing those products to the market. And we got the largest, that we know of, field service force in the world around HVAC systems, over 4,500 people out delivering that are employees of the company. And you combine them all together with investments in digital. And I feel like it's been not a flash in the pan around something happening in the fourth quarter. It's been good for a long time. And it's up to us to continue to innovate and to continue invest in the channel. Half the investments or more than we're making in 2017, again, go back into the channel itself, not just into product. We look at Compression Technologies, similar investments happening there; we're seeing good growth on the service side. You had asked reference to CAPCO, you have to look at CAPCO, and there's a 5-point swing just in currency. CAPCO would have shown a 3-point gain, we show a 2-point headwind in currency, 5-point net. We back out, look at the organic growth, I think they were minus 5, we were minus 4. There's other subtleties in the business, but look, we're all, I think, in the compressor business, looking forward to brighter days. I don't think there's a read-through when you do the side-by-side math between CAPCO and us around the difference in performance.

That was very informative. Regarding capital allocation, what does the $1.5 billion target indicate? Does it suggest that there is an intention to use that amount, but it won’t be deployed if there are no opportunities? How do you balance mergers and acquisitions with share buybacks? If you haven't utilized that capital by this time next year, what would be the reason?

Yes, I think you had it right in your note this morning, Nigel. $1.5 billion is what we're saying we're targeting to deploy in 2017. And $250 million of that, we've already said, look, that's going to control any kind of dilution in share count. It leaves $1.25 billion left, and we're going to be really smart about how to deploy that. So very patient, very selective around the M&A front. And we're going to be patient around share repurchase. But between the 2, we expect to deploy $1.25 billion, and we're just going to update you as we go through the year. It's difficult to forecast that on an EPS basis because certainly, on share count, it matters when and where you buy shares during the year through average back in. And M&A, clearly, on a GAAP basis, EPS accretion is difficult to see in a partial year, maybe even within the first full year. So it's difficult to forecast that. It's dependent on the actual target.

Just following up on Shannon's question about free cash flow. You mentioned how you've focused this year on various factors. Was there a pull forward into 2016? I didn't expect 2017 to be down as much as it is. You indicated that the conversion rate is sustainable, and being above 100% is positive, but I’m surprised by the year-over-year decline. I’m curious if there was anything unusual about the performance in 2016.

No. There was really nothing that was unusual about the 2016 performance, Steve. What I did is I look at 2017, as I did a couple of things. One, on working capital, I was really allowing working capital to go back up to around the 4% level, and I'll tell you why. As our markets are a little bit lumpy, choppy, some of them recovering, I want to make sure that our businesses have the option to have inventory on hand so that not only can we meet customer requirements, but that we can meet on-time delivery requirements. So I'm giving us room for a little more working capital. And really, I'm primarily talking about inventory in terms of 2017. The other part of that is our capital expenditures are actually going up a bit year-over-year. I gave you a guide of $250 million. And really, the majority of the increase in the CapEx year-over-year is really in our factories, in productivity producing projects and things like, primarily, precision machining in the factory. So I gave a little room for all of that, and that really takes it down to the $1.1 billion to $1.2 billion level.

Yes, well on the $50 million, we'll probably see $10 million in '17. Then we'll go to something more full run rate, probably $20 million in '18 on that $50 million.

Great. And then one last question, just on the first quarter, maybe my clients are going to hate me because they don't want guidance anymore, but I think it's good to at least have a nice framework out there. Normal seasonality at least that we calculated, it gets me in the kind of the low- to mid-50s from an EPS perspective. Is that too far off?

From a seasonality perspective, Steve, we went back over 5 years, and we're pretty much now, I think, dialing in. So first quarter usually is kind of 10% to 12% of EPS for the year. And then we're kind of a front half, back half 45%, 55% sort of company. You shouldn't get too far off with that sort of math going. Steve, before you cut off too, I want to thank you for spending as much time as you did at the ASHRAE show with our team. They really appreciated you stopping and spending time with them.

First, so I guess my first question is that maybe just touch a little bit on price cost. Clearly, a little bit of a headwind in 4Q. And talk a little bit about what kind of pricing you think you can get through across your portfolio in 2017. And to the extent that you can talk about cadence, that would be helpful as well.

Sure, Joe. Let me start out and give you some basic parameters around this. So we knew going into Q4 that we were going to be in an inflationary environment for steel. Pricing did not offset the inflation in the fourth quarter, so we were down 40 basis points, as you saw on the slides and heard from our commentary. As we look at 2017, we've got that currently pegged at price over material inflation at about 10 basis points, really working towards trying to get back to our norm of 20 to 30 basis points. But let me talk a little bit about what's happening in 2017. So if you think about what drives the material inflation, it's really all around steel. The nonferrous, so the copper and the aluminum, first of all, we're locked about 68% on copper going into 2017, but those should be relatively flat, so neither inflationary or deflationary as we see it right now. Steel has 2 components to it, one of which is just the raw commodity that's there. And then an even bigger part of that is actually the Tier 2 materials that contain steel that become inflationary. And one of the questions that I ask our group and wanted to pass on as we think about that is my question was, can we just really negotiate with the supply base? And part of this is really on how we've done contracts and written in escalation clauses. So long story short, steel and components that contain steel are going to be inflationary in 2017. And like I say, we'll continue to work price as we go throughout the organization. Now when you think about pricing, you think about different areas. We've been successful at getting price in both of our segments in 2016, and I think we'll get price in both segments in 2017. Asia is going to be tough. That one's an interesting market. Some of the others, again, price is not for us just a catalog and a price on a particular item. We're baking price into every engineered order type of project as we go along. So again, pricing is going to be a work in progress. I think there is going to be a little pressure on that as we go into 2017, but inflation comes from steel.

Joe, recognizing you've been with us now a couple of years, but if you go back all the way to 2010, I know personally, even late 2009, we put in place and have been adapting and training to all the methods and tools for pricing and systems around the company. So there is a lot of rigor in the operating system around that, a lot of reporting and remediation around that, mitigation around that. So on a topic like this, you'd have to go back to a 7-year record of every year being able to deliver on that. I don't suggest that it's going to change in 2017. So it's a little bit here on the benefit of the doubt associated with the tools and the methods of training that we've done over the years.

That's helpful, both of you guys. I guess, maybe my one follow-up, maybe just switching gears to like Thermo for a second. Orders turned positive this quarter. I know that you're calling for North America truck trailer to be down low-teens in 2017. Your largest competitor, who we just saw at the same conference, I think, is forecasting down mid-single-digits. Is there any reason why there'd be either a lag or a change in the trajectory that either of you see for 2017?

Well, two factors that always play here. One is around which side of customers are buying and which are not. And you'll see anomalies quarter to quarter about kind of who came to the table. So in the fourth quarter, certainly our customers came to the table and placed orders, which is great. The second, really, piece of this thing is that it's awfully early to call. ACT is saying 43,000 units. We've got about 40,000. If you want to write back to ACT, now you're sort of in that range that our competitor would have outlined for you. We tend to think historically, with the exception of last year, that they kind of met in the middle somewhere. So we're a little bit more conservative around the 40,000-unit ACT number versus 43,000. That's probably explaining the difference now we're seeing in the market.

Just a question about the fourth quarter reinvestment on security and IT. A, could you just talk a little bit more about it? And second, I'm just really curious, what was the timing of the decision to make this reinvestment? And what I am trying to understand, we're starting to get a sense that companies are getting more comfortable with growth and actually, for the first time in several years, are choosing to put money into their businesses again. And I was just trying to understand if that's what's happening at Ingersoll Rand, or if there was something else?

Yes. One of the things, Andrew, when it comes to infrastructure and cybersecurity, which are often related, I think once you have the idea that you need to do something or want to do something, I think that common thinking would be that sooner is typically better than later, if you think that you've got something you want to plug. That's generally sort of the thought process, the management decision to do that. It's also why, frankly, you should always understand we're trying to do the right things for the long run, not for the quarter. So that in and of itself may not have been the difference. I mean, it was more the other discrete items that are difficult, if not impossible, to forecast, stock-based comp, incentive comp, certainly get that packed by legal entity as opposed to taxed by geography or business unit is more nuanced. But that's one where, generally speaking, if you need to spend it, sooner is typically better than later, and that's been our approach.

I would like to add a bit to that, Andrew. Looking back at the full year of 2016, we began the year with regular discussions across all teams in the company. We emphasized the importance of not allowing our costs to exceed the revenue expectations. If you analyze the corporate costs for the first three quarters of 2016, you'll notice our spending was actually below what would typically be expected for a $240 million revenue year. While being under budget doesn't mean you should increase spending unnecessarily, it does impact our decision-making, especially when there are necessary expenses. This year, our costs across various functions, including IT, legal, HR, and finance, remained flat compared to 2015, and we expect them to stay flat in 2017 as well. There's also an element of timing involved in this, which may not account for the differences in our guidance, but I wanted to share our thought process as we approached the fourth quarter.

And just to be clear, and what Sue said, so '15, '16, '17, the core functional costs have been absolutely flat, which has been our objective, what we're driving to. All the swing you see are in things like stock-based comp, pensions, adjustments that are really happening sort of around those core functional costs.

Got you. The other thing, you made a specific commentary about seasonality on Industrial in 2017, and you did call it out. And so what's different versus history on this quarterly variability in the Industrial business?

Andrew, the only comparison I think we made was comparing Q4 '16 to Q4 '15 because Q4 '15 had that mammoth load of Cameron shipments, which drove the difficult comp for quarter 4. Not a lot of seasonality in Industrial beyond that, that we would call out, with the exception that, for some reason, with large compressors, the kind that are put into gas and energy applications, have tended to be more fourth quarter loaded. But I'm not sure that that's an actual seasonal phenomenon as opposed to sort of when we're booking and shipping orders.

So just to correct, I guess I misunderstood. So there is nothing different about Industrial seasonality in 2017?

No, Andrew. I think the comment that we were actually making in, perhaps we didn't make it as well, is we thought was that what we didn't want anyone to do was to take and draw a straight line on margin improvement each and every quarter in the Industrial business. We were saying that it could be a little bit lumpy from quarter-to-quarter and would follow its typical pattern. So we just didn't want anybody to get concerned if there was some variation there. So it was a pretty simple comment that might have been confusing.

I was hoping to get a little bit more color on the residential bookings at up low-teens, maybe some color regarding the product, the mix, where this year preferences look to be in 2017 and was there any prebuy involved.

There was no prebuy, but I think it's important to note that our residential product has completely transformed over the last three years. We're making some minor adjustments, and we've discovered that as the product mixes shift to 14 SEER and higher, it resonates well with our dealer network. Relating back to the commercial discussion, this has been a long-term investment in refining our product portfolio and repositioning our dealer base to effectively sell low, medium, and high-priced products. We've also seen success in penetrating the residential construction market as well as the owner-occupied non-residential market. Overall, we are seeing positive results from strong product development, channel development, and a consistent long-term strategy.

Deane, regarding your question on SEER, in 2016, the combined revenue from the 13 and 14 SEER products accounted for approximately 50% of our total revenues, while the 15 SEER and higher products represented a smaller percentage. Essentially, we observed a transition from the 13 SEER to the 14 SEER product, with the 15 SEER and above remaining relatively stable.

Got it. And then just as a follow-up, there was an interesting development recently with your primary competitor in golf carts investing in Arctic Cat. So does that change your thinking in any way of how you want to be positioned? You did mention the new product launch of Onward. I went online just now and took a look at it. Those look pretty cool brands for a golf cart, but looks like it's an organic focus for you all with Club Car. But maybe some comments there.

Yes, it looks better with the lift kit, Deane. That picture shows that big wheels and a lift kit are essential. We're focusing organically because we believe the brand has potential. We have consistently concentrated on consumer golf and utility. It's a dedicated effort to enter the consumer low-speed vehicle and personal vehicle markets. We're targeting golf and car communities, small vehicle communities, and hospitality and recreation venues, not high-speed travel through rough terrain.

This is Seth Girsky on for Andy. Last quarter, you mentioned expecting the Asia HVAC market to remain flat or decline in 2017. While 3Q bookings were flat, this quarter, bookings in Asia HVAC showed high teens growth. Could you share your expectations for Asia HVAC in 2017?

It was a really strong fourth quarter. I anticipate a more moderate outlook for Asia, likely in the mid-single digits for the entire year. We had a unique opportunity to secure a significant number of orders from a small group of customers who are making large purchases, which may lead to variability. Nevertheless, I believe it will be a cycle, and by the end of the day, we will see mid-single digit growth.

Got it. That makes sense. In the Industrial segment, Material Handling appears to still be facing challenges. Could you share your perspective on when we might see a bottoming out in the Material Handling market as oil prices continue to improve?

Yes, it has to do with really the count of offshore rigs increasing. That's probably the biggest determinant. Land rigs have an effect, but the content that we provide in a land rig versus an offshore rig is going to be dramatically different. So I'm pleased to see really utilization of offshore rigs. You're not going to see a full recovery in that business. Incredible margins, fantastic business. That's why it hurts when it's actually down. You really have a dramatic effect on the margins for the segment. Frankly, it's about 1 point in the fourth quarter. So small business, big impact. We love it when it's up; it hurts when it's down.

Mike, I'm currently at ASHRAE, and I've noticed that most people I speak with are experiencing growth in VRF in North America of about 15% to 20%, depending on the metrics used. I know you've previously mentioned that around 25% of the market volume is going through your channels. However, it's clear that much of that is non-Trane product, and the actual contribution from Trane or similar products seems quite low. I've observed that other companies have successfully transitioned to their own products or those from joint ventures. What is your plan and strategy in this area? It appears to be one of the few segments where you don't really own the product and lack vertical integration, which seems like a significant opportunity.

Yes, Steve, look. One of the things here is we have a very definitive plan of what we're doing. I'm not going to disclose it here for strategic reasons to do that, but I'll tell you that it's a source of investment in Q4. It's a large business in Asia, and it's growing. And we make and co-develop our own product there with partners. Here, our growth rates are higher than the rates you're reporting. So we're seeing higher growth rates in our unitary business and higher growth rates than what you're seeing. Our focus really is on the VRF business, not on the mini-split business. We think that's where the value is. That's where controls matter. That's where hybrid systems come into play. It's where our channel works and where service is a possibility. So again, our focus is on VRF. You've seen Trane-branded products there in the U.S. Mini-splits, we're a bit more agnostic that we serve the market. We're not as caught up in whether that says Trane or Trane or somebody else or somebody else going through our market.

Okay, that's helpful. Going back to the cash flow discussion for 2017, it seems like at the midpoint we're looking at 100% conversion, and Sue mentioned a 4% working capital target. However, Mike, we've been discussing lean conversion and improved inventory and management for almost a decade. Can you provide some insight on why the inventory levels can't be lower while still meeting channel demand? Is it simply a transition of inventory from raw and work in process to finished goods? What's happening there?

Yes. What matters to us isn't whether it's 3.6 or 4, or whether inventory turns are 6.8 or 6.9. Our goal is to achieve 100% on-time customer shipments with cycle times that our competitors cannot match, allowing us to capture available discretionary business. We aim to find a balance between these factors. As long as we are increasing margins and gaining market share, we believe we have a successful strategy. The focus should not be on creating problems that hinder our ability to compete effectively. As you know, optimizing cycle time and compressing it adds value, not only in terms of working capital but also in growth and operating margins. This has always been our priority. Whether we reach 3.6 or 4 is less critical; we recognize that our working capital and inventory turns are already at a high standard, likely in the top quartile. Last year, our return on invested capital was close to 24%, with cash flow return on invested capital also at 24%. So let's continue to grow the company and improve margins. It'll never let up. I promise you. As long as I'm breathing, it will never let up.

I'd like to thank everyone for joining on today's call, and thank you for your interest in Ingersoll Rand. As always, we'll be available in the coming days and weeks to take any questions that you may have, so feel free to give us a call. And we'll also be on the road quite a bit this year, so we look forward to meeting you in person. Thank you, and have a great day.