Trane Technologies plc (TT) — Q3 2017 Earnings Call Transcript

Thanks, operator. Good morning, and thank you for joining us for Ingersoll Rand's third quarter earnings conference call. This call is being webcast on our website at ingersollrand.com, where you'll find the accompanying presentation. We're 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 our actual results to differ materially from our 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, everyone, for joining us today. I'll start this morning by discussing how focused execution of our strategy underpins our ability to deliver sustainable, high levels of performance over time. I'll also provide comments on how we're thinking about our business and our end markets broadly as we close out solid performance in 2017 and move into what we expect to be another strong year in 2018. Sue will discuss our third quarter performance in more detail and address some key topics we know that are on the minds of investors. I'll then close with a brief summary before we take your questions. As I said on prior calls, our overall strategy remains straightforward. We believe our business operating system, people, and culture are sources of competitive advantage. First, our business strategy is grounded in anticipating and addressing global trends that positively impact many of the world's most pressing sustainability challenges. We focus on delivering the most reliable, energy-efficient, and environmentally friendly products and services in durable growing markets. In our case, it's an orientation toward the importance of sustainability, which is enabled by digital and other exponential technologies growing at dramatic rates that are enabling new business models and sources of productivity in a world that will increasingly value the conservation of resources. We excel at delivering energy efficiency and reducing greenhouse gas emissions, reducing food waste, preserving natural resources, and generating productivity for our customers. It's what we do, and it's what we're known for. We maintain a healthy level of investment in our businesses to sustain leading brands, which are #1 or #2 in virtually every market in which we participate. Second, we excel at delivering strong top line, incremental margins and free cash flow through our business operating system. Our business operating system is continuously improving and underpins everything that we do. It enables us to consistently generate high levels of free cash flow, which powers our dynamic capital allocation strategy. One example of our capital allocation strategy is the acquisition we entered into this week that strengthens our telematics portfolio, an important component of our connected technology strategy. Sue will cover this within topics of interest later in our call. Our year-to-date results continue our strong track record of performance and position us well for a solid finish to 2017 and strong momentum going into 2018. Sue will discuss the details of the quarter in a few minutes. So I'd like to turn my attention to discussing where we are at this stage in the year and how we're thinking about key aspects of our business going forward. Moving to Slide 4. We're going to follow the format we started last quarter and discuss how 2017 is shaping up relative to our expectations, so you get a feel of how the landscape is evolving. I'll touch on some of the areas that may read through to 2018 as we're in the midst of our 2018 planning now, but I want to be clear upfront that we'll give 2018 guidance with our Q4 earnings call, so not going to go into any specific detail and targets at this time. I know 2018 is on many investors' minds, but it's important for us to complete our planning process in order to provide you with a high-quality discussion on 2018 that we all expect. I'll hit the key areas that are most important to investors in order to keep the discussion focused, so if we don't hit something here, we'll cover it in the Q&A session. The first point I'll make is probably the most important. We are on track to deliver against the revenue, adjusted EPS, free cash flow, and capital allocation guidance that we set out at the beginning of the year. We're using all the tools in our business operating system to get there and given evolving market dynamics, it is a bit different than what we envisioned when we gave guidance back in January. I'm proud of the way our team has pulled together in some challenging market conditions to achieve these goals, which should yield strong revenue growth of about 4.5%, 9% EPS growth, and free cash flow of approximately $1.2 billion. In 2017, orders and revenues had been consistently strong, our end markets on balance have been solid and the outlook for the markets continues to be healthy, looking into 2018. Our HVAC businesses are performing well and will have a strong order and margin expansion in 2017. Our Transport business is demonstrating the resiliency we expect with a modest decline in revenues and margins despite challenging markets. Our Industrial business is recovering nicely with order growth and margin expansion ahead of our expectations. There are a lot of things working well for us. One area that we're not satisfied with and we expect to improve on in 2018 is our operating leverage. Our business model is rooted in our ability to drive margin expansion in low growth environments and we did not make enough progress expanding incremental margins for the enterprise in 2017. We were negatively impacted by a few key factors in 2017 including higher-than-expected and persistent inflation, mix of business as we penetrated underserved Commercial HVAC markets, most notably in China, which at present carry lower gross margins than our portfolio average, but still are accretive to our EPS. This business is particularly accretive when you add in the highly profitable service tails from applied equipment sales in the mid- to long-term. The way our bridges on price versus cost are compiled, the impact in moving into these newer markets shows up as price although some would probably categorize this as business mix. Rather than confuse anybody, we've kept the designation in price consistent for all of 2017, but I believe it is worth noting this distinction as it has a pronounced impact in how our price versus cost spread shows up in the bridge. We're seeing better than expected success in these markets from China with approximately 20% order growth year-to-date and low 30s order growth in the third quarter. This is putting increased pressure on climate and enterprise margins as China is experiencing the impacts of both negative price and inflation, whereas the majority of our businesses are seeing positive price. We're in the process of developing our 2018 operating plan, and we're focused on accelerating productivity initiatives to drive higher leverage in 2018 and beyond. Increased focus here will drive more direct control of our margin expansion irrespective of market conditions. We're also seeing inflation moderating in 2018 as we begin to lap the inflation we saw throughout 2017, so we should see reduced headwinds here. Similarly on the China market penetration strategy, we begin to lap the lower gross margins for those markets in 2018, so we anticipate the pressure on leverage in the region moderating as well. Moving through the update. Year-to-date, our end markets continue to perform well with strong broad-based orders in revenue growth. Our outlook is for our end markets to remain healthy through at least 2018. Execution across the business continues to be solid. The tragic, unprecedented natural disasters in the third quarter took a toll on our 750 associates in Puerto Rico, our customers, and more broadly, on our markets. Our thoughts are with our employees, their families, and all the lives that were impacted by these terrible tragedies. Financially, these natural disasters had an impact on us in the third quarter. We estimate that the impact was between $0.04 to $0.05 of EPS when you take into account downtime in our Thermo King, Puerto Rico manufacturing facility, the disaster relief funds we provided to assist our employees, and the three days of lost sales and productivity in two of our largest HVAC markets in Florida and Houston. Slide 6 lays out the main impacted areas, and Sue will cover these in more detail in a few minutes. We think we'll see some recovery in the fourth quarter and in 2018, and there likely will be additional market opportunities over the next one to three years as building occurs in the affected geographies. So laid out earlier, the impact of our strategy to compete in new markets in Asia and the Middle East is driving exceptional growth for us in these markets, but the impact to leverage and the price versus cost equation was significant in the quarter. Again, we see these areas improving as we move into 2018, as we lap 2017 inflation and gross margin headwinds. We're also driving aggressive productivity plans for 2018 to expand margins. The next topic is on price versus cost, as we see it at this stage in the year. Things are shaping up fairly consistent with what we expected coming out of the second quarter earnings call. Pricing remains positive in both Climate and Industrial. The areas that are impacting our price versus cost equation across both Climate and at the enterprise-level are predominantly emanating from Asia and to a lesser extent, the Middle East as we previously outlined. With regard to our Industrial segment, this segment has been performing well in 2017 and ahead of our expectations. We've seen strong bookings growth and margin expansion in the segment. And the last topic is an update on our Climate businesses broadly. Commercial HVAC equipment businesses remain strong with high single-digit order growth in Q3. Our Commercial pipeline and outlook continue to show healthy markets going forward. Our Residential and Transport outlooks are also on track with our expectations. Focused execution of our strategy will deliver strong performance over time, and we're excited about the opportunities that lie ahead in 2018 and beyond. I hope that this has given you some important insights on how our outlook has evolved through this point in the year. And now I'll turn it over to Sue to discuss the third quarter in more detail.

Thank you, Mike. Please go to Slide #5. I'd like to begin with a summary of main points to take away from today's call. As Mike discussed, we drove solid operating and financial results in the third quarter with adjusted earnings per share of $1.44 despite business disruptions from natural disasters in the quarter negatively impacting results by approximately $0.04 to $0.05 per share. Our adjusted tax rate was 17.7% driven by the timing of a number of tax planning-related discrete items that hit in the third quarter that were expected in the second half of 2017. We continue to expect our full year 2017 adjusted tax rate to be approximately 21% or the lower end of our previous range. Bookings growth was strong with growth in both segments and in every strategic business unit. On the Climate side, organic bookings were up mid-single digits in both Commercial HVAC and Transport, and up low single digits in Residential with another quarter of share gains. We also drove high-teens Commercial organic bookings growth in Asia and Europe, Middle East, and Africa. Climate organic revenues were also higher, up 3% in the quarter. Our Industrial segment continues on a path of steady improvement and is actually performing a bit better than our guidance with strong organic bookings growth of 5% overall. Compression Technologies had growth across small and medium compressors and particular strength in large compressors. We also drove a 90-basis-point improvement in adjusted operating margins on essentially flat revenues. Flat revenues were also better than our expectations given difficult compares versus Q3 of 2016 as we discussed on our second quarter call. In January, we laid out our capital allocation priorities for 2017, including spending approximately $430 million on dividends and an additional $1.5 billion on a combination of share buybacks and acquisitions, and we're on track to achieve those priorities. We also discussed our objective to grow our dividend at or above the rate of our earnings growth. In August, we raised our dividend by 12.5% to an annualized rate of $1.80 per share. Year-to-date through October, we've spent $1 billion on share buybacks and $318 million in dividends. We also spent or entered into commitments for approximately $200 million in acquisitions. Please go to Slide 6. During the third quarter, we saw positive and negative financial impacts from natural disasters, primarily the hurricanes that hit the Caribbean, Florida, and Texas. We saw increased commercial rental activity and increased part sales in the third quarter. Offsetting the positive financial impacts, shipments for Transport in our Puerto Rico facility, residential and small electric vehicles were also delayed and our businesses were down for several days resulting in lower absorption, productivity, and other additional costs. We expect to regain some of the deferred business in the fourth quarter, and we are currently assessing the potential impacts for 2018. If the recovery from these storms follows past experience, we'd expect to see an overall strengthening in the underlying markets in the impacted areas over time rather than a spike of activity in any given month. Please go to Slide #7. The focused execution of our business strategy underpinned by our business operating system enabled us to drive solid year-over-year financial performance. Organic revenues and adjusted earnings per share increased 2%. Adjusted operating margins declined 40 basis points year-over-year, impacted by the $0.04 to $0.05 earnings per share headwinds from natural disasters. As Mike discussed earlier, our strategy of penetrating very large underserved markets in China in Commercial HVAC is resulting in strong bookings growth with China Commercial HVAC up low 20s percent year-to-date and up low 30s percent in Q3. In the short term, the negative impact of this growth is approximately 55 basis points of margin contraction at the enterprise-level in Q3, although still accretive to our earnings per share year-to-date. It is expected to represent 75% of the negative price-cost spread for the full year 2017. Please go to Slide #8. As we've discussed, organic orders were strong in the third quarter with increased activity in both our Climate and Industrial businesses. Organic Commercial HVAC bookings were up mid-single digits. Q3 2017 North America bookings were up low single digits. Outside of North America, Commercial HVAC bookings were broad-based with high-teens growth in EMEA and Asia, and mid-teens growth in Latin America. Transport organic bookings were up mid-single digits with gains in North America, Latin America, and Asia. Bookings growth spanned the product portfolio with gains in trailer, truck, bus, aftermarket, APU, and Marine. Industrial organic bookings were up 5% in the quarter with growth across all Industrial businesses. Regionally, North America and Asia bookings gains were offset by declines in Latin America and Europe, Middle East, and Africa. Please go to Slide #9. In our Climate segment, organic revenue was up low single digits in North America, up mid-single digits in Europe, and up low teens in Asia. Globally, equipment was up low single digits and aftermarket was up mid-single digits. In our Industrial segment, organic revenue was down 1%. We had large compressors shipments in Q3 of 2016 that did not repeat this year. Regionally, we saw low single-digit growth in North America and Latin America. In our Compression Technology business, North America was up low single digits in parts and services. Industrial Products were up mid-single digits and Club Car had high single-digit growth with continued success in Onward personal vehicles. Overall, North America and international revenues were up low single digits, netting a 2% organic growth rate for the enterprise. Please go to Slide #10. Q3 adjusted operating margin declined 40 basis points, primarily driven by volume, productivity improvement and positive price, more than offset by natural disasters as previously discussed, and material inflation including the negative impact of price versus costs largely driven by our penetration of underserved markets in China and competitive pricing in the Middle East. The impact of China and the Middle East were greater than we anticipated earlier in the year driven by higher volumes and forecast, and higher-than-expected material inflation, which widened the negative price-cost spread. Outside of these markets, the price versus cost spread was largely in line with our expectations. Please go to Slide 11. We covered the main points from this slide on prior slides. Performance in the quarter was strong on bookings and revenues. Excluding the natural disaster impacts in Climate, margins would have been roughly flat. Margin declines were largely attributable to our China strategy and the negative price versus cost spread in the Middle East, which combined, were approximately negative 65 basis points. Please go to Slide 12. We've also covered the highlights of this slide on prior slides. Our Industrial business continues to outperform our expectations and deliver strong improvement in bookings and margins on relatively flat revenues. Our continued focus on improving the fundamental operations of the business is yielding good results. Please go to Slide 13. Free cash flow was $408 million for the third quarter driven largely by strong profits. Working capital as a percentage of revenue remains on track to our expectations for 2017. Our guidance for free cash flow remains unchanged at $1.2 billion. Additionally, our balance sheet continues to strengthen, which provides optionality as our markets continue to evolve. Please go to Slide 14. Continued strong cash flows in 2017 are powering our dynamic capital allocation strategy, employing capital where it earns the best returns. In January, we laid out our 2017 capital allocation priorities and they remain unchanged. Our first priority is making high ROI investments in our business to drive productivity and to maintain our product leadership position. The secondary is maintaining a strong balance sheet with BBB ratings and healthy optionalities as our markets evolve. The third area is our commitment to paying a highly competitive, reliable dividend that grows at or above the rate of earnings growth over time. The fourth priority is strategic acquisitions and share repurchases. In January of this year, we committed to spend $1.5 billion between these two areas and we're on track to achieve these commitments. Year-to-date, we've spent approximately $1 billion on share repurchases and approximately $200 million has been spent or committed to acquisitions. By the end of 2017, we expect to have approximately $400 million to $500 million spent or committed for acquisitions. As we look forward to 2018 and beyond, our overarching strategy and priorities remain the same. Please go to Slide 15. For 2017, we're maintaining our revenue, earnings per share, and cash flow guidance. For modeling purposes, we also wanted to provide tax rate guidance, which should come in at the lower end of our previous range or approximately 21%. For the full year, we expect fully diluted shares to approximate 258 million based on share repurchases in 2017. Please go to Slide 17. We've received positive feedback on the section covering key topics we know are of interest to you in our prepared remarks, so we'll cover a few of these topics on the next couple of slides. The first topic is HVAC order growth in the third quarter. Our HVAC markets remain very healthy. In the third quarter, orders were higher in all of our major geographic regions. We had especially strong order growth in overseas markets up by high teens. North America Commercial HVAC continues to see good order growth against difficult comparisons with 2016. Residential HVAC orders also improved compared with record activity last year, and the business continues its steady market share improvement. Please go to Slide 18. The last topic for today is the acquisition pipeline. As previously discussed, we're expecting to close on or have signed agreements on approximately $400 million to $500 million in acquisitions in 2017. We are focused on channel and technology investments that add to our existing core businesses. Most recently, we entered into an agreement to acquire a telematics company. This acquisition will complement our 2015 acquisition of Celtrak and allow us to expand our expertise in telematics, in addition to the many services it already provides for our small electric vehicles business today. Now I'd like to turn it over to Mike.

Thank you, Sue. So on closing on Slide 19. We expect to deliver our 2017 plan for revenue growth, adjusted EPS, free cash flow, utilizing our business operating system and building a thriving, more valuable Ingersoll Rand. To summarize, our Climate segment remains strong, led by our Commercial and Residential HVAC businesses, which are focused on growth areas with equipment, controls, and service. Our Transport Refrigeration business is diverse and agile, and is executing their strategy and delivering against our high expectations in a challenging market. Our Industrial business is improving ahead of our expectations for growth and margin expansion. 75% of our negative price versus cost spread in 2017 is expected to come from very strong growth in Asia, primarily China. We expect both the inflation and pricing headwinds to moderate heading into 2018. The balance of our markets should see moderating inflation in 2018 as well as they lap 2017 inflation. Nonetheless, we're accelerating our 2018 productivity initiatives to drive more direct control over margin expansion irrespective of market conditions. We're also on track to achieve the capital allocation priorities we laid out at the beginning of 2017. We expect to deploy roughly $1.9 billion in cash in the form of dividends, buybacks, and acquisitions. We have a tremendous depth of talented people, and our culture remains as strong as ever. And taken together, I'm confident that with this formula, we'll continue to deliver top-tier financial and operating performance. So with that, Sue and I will now be happy to take your questions.

Mike, you gave a lot of color on your price versus costs issues, and you talked about how most of the issues were emanating from China and the Middle East. I know you don't want to give detail on 2018, but as you tend to shift the overall company, it's a little more of these longer cycle Applied HVAC orders, especially in international markets, how difficult do you think it'll be to get your arms around price versus cost? And what could you do specific on these regions where competition is significant and inflation is still reasonably high?

Yes, Andy, I think maybe it's best for us to start with what is our China strategy historically and how we're evolving, and I think that will answer a lot of questions for you. First of all, China as a country and Asia as a region have some of the highest operating margins that we have across the HVAC space, still today, even this quarter. Historically, we've been a Tier 1 and Tier 2 city-focused company and largely on applied equipment, and we've been very successful there. We've penetrated those markets with very high share, and often Trane is the basis of design in many of these projects. What we've done over the last two years and you're seeing it this year in spades, is we've extended to Tier 3 and Tier 4 cities. We've also launched both localized, ducted and ductless unitary products nationally. We've penetrated and are penetrating larger infrastructure projects, things like subways, airports, and the electronics vertical specifically, which is Applied. And those three things in Tier 3, Tier 4 cities help drive Trane as a basis of design in those cities as well. It's been a formula we've followed for years, and it's been very successful for us. We know that this grows a large service tail, and we know that we grow margins by leveraging the SG&A and the manufacturing base around that. So to put it in context, the strategy has been very successful. We put a PGT in place about two years ago. We fully localized our product portfolio in unitary, ducted and ductless, we've been there and Applied for some time. We added 178 selling and marketing people onto the street over the last 12 months, and 165 of those we put in just since January, so the project pipeline we're seeing in China is up 211%. So to speak for clarity, it's three times larger than what it would have been last year at the same time around that pipeline. So year-to-date, we've seen bookings growth in unitary; it's actually been 40-plus percent. We've had mid-20s revenue growth in unitary. Unitary is now 25% of the mix that we have in equipment in China. We've been able to grow the Applied business at twice the market rate year-to-date, and we're seeing excellent service growth. So again, it's become so successful that it really is, we classify it as price, but we're growing this accretively to the company and long term it's the right and most successful strategy that we know how to conduct. By the way, we would have a similar strategy; there are nuances to what we'll be doing in Europe or Latin America, but every region of the world has its own unique strategy, and in China, it's just been very successful for us.

Mike, that's helpful color. And then just shifting gears to North American Commercial HVAC bookings, they were up low single digits against tough comp as you talk about it. I think it's a good result compared to last quarter, but can you give us a little more color regarding what you're seeing in the overall North American HVAC market? There's been slowing like unitary. You talked about Applied HVAC improving there. Do you still see a good runway in Applied HVAC, so North American Commercial HVAC bookings should be up low single digits or better moving forward?

Yes, I would say first as a starting point, nothing has changed that would make us less bullish on the end markets than we were five years ago when we talked to everybody at Analyst Day. Our outlook continues to be very positive. We'll see contingent... Low single digit to mid-single digit growth in North America Commercial, and that we're going to drive share gains. Our project pipeline is actually stronger today than it was last year at the same time. We also think inflation in 2018 is fairly consistent with what we expected five months ago. We think it's going to be much more copper-related, which is much easier for us to set pricing and cost into the factories, about how to price and cover that as supposed to steel, which is very difficult than the longer lead items, so we think that, that will be more manageable for us. So staying with where we were five months ago, the CAGR of 4% to 4.5% over the three-year period, 11% to 13% EPS growth over that period, still very much in the cards for us. We're very confident about that. We'll update that in the fourth quarter, but a lot of that underpinned that we're seeing strength not only in North America but across the globe, and you're seeing that in even Latin America. As we pointed out, mid-teens growth rate in Latin America, finally seeing some recovery there, and don't forget, that's an important market for us too. It's a $0.5 billion in revenue in the Climate space for us.

Mike, so I just wanted to go back and visit the price cost. So the 55 bps impact from Asia and Middle East you called out, so just given your comments on China, is that more accurately a mix impact as opposed to price cost impact?

Yes, Nigel. It's a very specific definition we use and we say that if it's equipment coming out of a factory using the same machining and assembly processes, that we mark that as price. But clearly, what you're seeing in Tier 3 and Tier 4 cities is even more decontented product, and you're seeing that generally, those have done some of the local players that have been in that market. So it is mix more than it is price. But again, for consistency of what we've been talking about, we classify on the bridge as price just to keep it sort of straight for everybody at this point in time. But it is something that if you move past China, you look at, say Res for example. On the Residential in North American business, we grew margins considerably, we grew share considerably. We're managing that. If you go to the balance of the Commercial businesses, excluding the Middle East and Asia, we're largely covering inflation there and of course, in the Industrial side, we're covering inflation there completely. So it's really isolated to this penetration we're seeing in China. The Middle East is a bit different. Here you've got just this fact that you've got the same number of competitors fighting over fewer projects there, and so you're going to have a bit more competition there as well. In 2018, I think that we're clear that we've got moderating steel environment. We've got our copper environment that we can lock a good portion of it, understand at the beginning of the year. We feel like, generally speaking, it's a more manageable year in terms of the global material inflation, pricing scenario. And specific to Asia, it's really a matter of just getting to scale on some of these Tier 3, Tier 4 cities, getting additional service density in these cities, and we know how to grow margins from there. So again, it's a long-term view toward China. I think we see an improvement in 2018 in China leverage.

Right. Okay. But if you think about moving away from China, it’s a good problem to have if you're growing at that rate. Considering North America and Europe, how do you see the level of competition and pricing? Is it becoming more competitive, less competitive, or about balanced? How do you view this shift in competition?

Yes, there's nothing structurally different about the competition in these markets. We've had high teens growth before in Europe. We've had substantial growth in Europe over the last few years. It's really about new product introduction, around next-generation refrigerants, building out a controls portfolio, a wireless portfolio, double-digit growth there, more digital involvement in connecting our businesses remotely, and more service feet on the street. So it's always been a competitive environment, but you're able to differentiate that business on total cost of ownership, which is 90% of that equation is not the initial cost, it's the energy efficiency and the maintenance and reliability of the product over the long haul, and nothing's changed about our value proposition there at all.

And Nigel, it's Sue. Let me add a little bit of color on the pricing to that, I think, is important and it really doesn't come out in all of the detail that we've got. So we talked about that price is actually positive in both of the segments, which it is. The other piece of it is that the pricing that we have achieved in the year is actually higher than last year. Again, we know the inflationary pressures that we've got, but we have really been able to build positive pricing in the areas of the world, and like I said, in total, it is positive in dollar terms on a year-over-year basis, and it's fairly significant. And it does have the headwind in there on price from Asia. So I don't want anyone to think that the pricing is actually not strong and that we haven't in pricing in 2017; we actually have, and it's actually stronger than it was in 2016.

That's an important point. And just to follow on SG&A. You talked about G&A as an important area of productivity improvement. And Mike, in the PR, you talked about ramping up productivity to offset some of these price material pressures. If we delineate between the S and the G&A in that 5% inflation, are we starting to see the G&A good news coming through but it's being masked by some of these sales investments, so is that on the come?

Yes. Compared to 2018, I can tell you that we'll generate over $300 million in productivity, as we do each year. This will primarily come from direct materials and be driven by engineering product management and operations. We're focusing on both direct and indirect aspects. What makes this different is that we've spent several quarters meticulously analyzing G&A and considerations for reducing it across the company. This will reflect in the G&A line over time, particularly between 2018 and 2020, starting to impact us in 2018. We also see opportunities from our efforts in automation and lean practices related to warehouse consolidations and logistics, which will also begin to show results in 2018. In addition to the usual high productivity levels we expect from our operating system, we are beginning several major projects that require the establishment of program offices staffed with talented individuals to manage what we anticipate will be hundreds of initiatives aligned with these broader goals. I'm optimistic about the leverage we'll achieve in 2018, 2019, and 2020 from these efforts, and I appreciate you bringing this up at your conference.

On the Commercial side, last quarter, you had mentioned the unitary markets on that slide as growing. What are you seeing in those markets ahead of this kind of regulatory transition in 2018? Do you expect any kind of pre-buy? And then just what's your outlook for kind of the core unitary markets going forward?

We experienced noticeable growth in North America during the quarter, which is encouraging. I don't expect a significant pre-buy in that region. While it would be beneficial if there were one, our current outlook doesn't suggest much of a pre-buy at this time. We are focusing on building inventory and discussing with customers about what they need to stock up on and if they are interested in acquiring that.

Okay, great. In Residential, you mentioned a new focus on channel development compared to last quarter. Could you clarify what you're doing in the channel beyond the digital initiatives you've previously discussed, and how this may differ from past years? I've heard that you are expanding storefronts similar to what Lennox has. Is this a strategy you have been quietly implementing?

Yes. We've got about 260 part stores today. Generally speaking, we've got them where we want them. We were adding up three last year, but we've got the coverage we generally need, and we're finding opportunities to transition some of that digitally so it doesn't all have to be brick-and-mortar, but there are 260 brick-and-mortar stores that are out there. What you're finding on unitary, both res and commercial, though, is there is this past year in particular, much more of a bias with customers replacing than repairing. So I do think that that's put a little bit of pressure on mix, but for the right reasons. You're really seeing people at this point in time doing wholesale replacements.

And Steve, I would also point out that in the context of our part stores, the 260 that Mike mentioned serve both Commercial and the Residential markets for us. And in fact, Commercial is a little heavier than Residential in terms of overall sales for those part stores.

And as you know, Steve, a lot of contractors don't identify themselves as one or the other.

That makes sense. And how fast did those grow over the last couple of years? What was the reference point for how many you added in 2016?

Yes, about a dozen. We've been focusing on that for quite some time. It hasn't been a major highlight of our company, but they play an essential role in our operations and we believe we have adequate coverage with the 260.

Mike, I would like to hear your thoughts on the overall mix within Climate for next year. You've experienced significant growth on the order side in China, but you've mentioned challenges related to pricing and mix which have resulted in lower growth compared to developed markets. How do you see this impacting the incremental margin for Climate going forward, especially in relation to this year? Do you believe you can achieve the 25% to 30% margin range on a year-over-year basis with the current initiatives and the changing mix?

I am confident that our planning for 2018 will lead us back to more normalized leverage in that business. We have developed a portfolio that should be flexible regardless of the specific product. As you know, Applied has somewhat lower margins but a strong service base over an extended period. Unitary provides a bit of a margin increase earlier, but there is enough growth happening globally that I anticipate good growth in 2018. Our pipeline indicates this as well. We believe we have a better mix to manage inflation shifts from steel to copper, making it easier to address pricing. Regarding your question about potential improvements in rooftop consolidation and G&A leverage, I have no doubt we can return to our historical levels.

Yes. So one of the issues, it's tough I know from an analyst and investor's perspective, is to take that Dodge or ABI data, and all you can do is take it at face value, but I've always said that, that Dodge data would really account for about 50% of what we consider to be the market, the visible market would be what Dodge is reporting, but 50% of it, frankly, it's the good 50%, is the negotiated piece of that, the negotiated retrofit of the performance contracting side of that, and that's where we've got the added benefit of looking at a pipeline, and those pipelines are well done. It's a process that we've been running in the company for a long time. It's a high level of confidence about what gets reported in there and how we assign close rates and probability to those projects. And so when I look at what I see for 2018, I see a good runway and good projects. There's a number of very large projects that have the possibility of going in 2018 for us that we generally wouldn't put into a forecast, we generally wouldn't even put into our guidance, but similar to what happened in 2016 or at historic '17 a little bit for us, we're going to have a little bit of it in 2018 as well. These projects would range from $50 million to $200 million apiece, and so they're going to move the numbers a great deal if, in fact, they hit. But excluding those, we see a strong pipeline, including those, is a very strong pipeline.

Maybe just switching to the Industrial segment for a change. So Compression Tech, you've had pretty good equipment orders growth in the last, say, 3 quarters. The sales though have been down substantially in equipment year-to-date. So I just wondered within Compression Tech, how we think about the conversion of that order number into equipment revenues and when we should start to see the equipment revenue line accelerate?

One really good data point for us that I'll tell you on this call, is that you know we're very indexed toward very large compressors. We're #1 in centrifugal compression technology in that space and of course, you know that that carries 40% to 50% pull-through on service along with that over time. And that has grown in the mid-20s, bookings growth during the year, and it grew in the mid-20s again in the third quarter. So we're feeling good about what that means for 2018 shipments and even beginning to formulate early 2019 shipments around some of the larger compressors. So that's an exciting change for us as it relates to backlog being built in large compressors, and it's exciting as it relates to the kind of leverage we expect to see from that.

Understood. And then just circling back on the productivity and other inflation line in your margin bridge. Historically in years when that has been good, it was about 100 basis point tailwinds, 2012 or 2014, 2015. When you're talking about more aggressive measures on productivity for next year, is that the type of tailwind you think that we should expect, about 100 bps from that line?

Julian, without setting guides, being careful here. That's sort of the general theme about how we think about setting plans would be to have about 100 bps of positive spread there. And then I take you back to my boxer analogy, that works great sitting in November and December and then as you get in the ring in January and you take a punch to figure out how to use all the tools at your disposal to win the fight. So that would be our sort of going in idea, and then what we want to make sure we're doing is we're putting some additional levers in place around ideas like rooftop consolidation and G&A that would be additive to that or in the event that inflation or pricing wouldn't behave the way we expect it to, we've got some additional countermeasures in place.

Mike, I want to revisit the situation in China, specifically regarding the development of our Tier 3 and Tier 4 strategy. I have a couple of questions. What is the status of product development for those regions? You mentioned making adjustments to our products to cater to those markets. Will there be a product refresh or redesign to effectively address this? Additionally, you mentioned the potential for service capture; what kind of service capture are you actually observing in those areas?

Yes. To clarify, Jeff, we now have all our products available in the market, including ducted, ductless, applied, and controls, so we are fully operational. What tends to occur is that specific features demanded in Tier 3 and Tier 4 cities often result in lower margins compared to what you might see in Beijing or Shanghai. As we explain the value and total cost of ownership over time, we find success with this approach. Currently, we are developing higher efficiency unitary products to reintroduce into Tier 1 and Tier 2 cities. This strategy is specifically focused on the Commercial sector, not on Residential. We are strategically enhancing our manufacturing, product management, operations, and sales teams, which has led to substantial execution by our team on the ground. It’s important to note that forecasting growth rates exceeding 40 percent isn't typical in planning; rather, we set ambitious goals, and our team has consistently met those challenges, demonstrating excellent execution. In the long term, we are building a robust foundation. Notably, over the last five years, half of the world's chillers have been installed in China, and we expect that to continue in the next five years. Therefore, it's crucial for us to establish a comprehensive presence in unitary, applied, controls, service, and digital sectors directly within the Commercial side, and that is our ongoing focus.

And on the service capture side of things? How's that playing out?

Yes, when I reflect on the years 2008 and 2009, the market share would have been around 10%, compared to 50% in North America or Western Europe. Currently, it stands at about 20% to 25%, and I expect it to grow over the next 5 to 10 years, resembling the situations in Western Europe and North America. The equipment is becoming increasingly advanced, and clients in China have much stricter expectations regarding energy efficiency and sustainability goals than in the past. All these factors contribute to the OEM having an advantage in maintaining the equipment.

How much actual physical capacity are you needing to add to accomplish this? I mean, there's certainly concerns that there's just excess manufacturing capacity in this space. Clearly, you're winning orders and growing your business and therefore, may need some, but how do you balance that risk reward?

We don't have a need to build additional factories in Asia. We've got a substantial footprint today, and we continue to lean it out. So lines are running faster in less space. And the more scale we get, the faster we can run the lines and hypothetically, the less space per dollar of margin we're going to need. So I don't have in the plans us needing to build a factory in China at any point in the future.

So maybe going back to price for a second. We heard from Watsco this morning that some of its vendors were starting to advertise pricing increases in the fourth quarter. Are you guys trying to pull forward price in 4Q or should we think about that as being more like a typical, like 1Q type event?

No. I mean, Joe, I think we follow our normal cadence, some of which might be in the fourth quarter, some in the first quarter, but there's no discussion that we're having about pulling any of that forward on a different schedule than normal.

And Joe, just to confirm, price in res is exceeding material inflation, and we grew margins again in the quarter. The hurricane impact to us was not in the res space. The res space, we were able to move inventory into the market. We're well positioned there. The impact for us was really losing three weeks of time in Puerto Rico at the manufacturing facility, and there, just to skip to it, it wasn't the factory itself. We had the factory up and running with around temporary power with plenty of diesel, and plenty of water; it was the fact that it was so difficult for our employees in the market that many of them lost their homes, lost everything, were just unable to come to work or didn't have the means to come to work to be able to build products. We're back up. We've been back up for a couple of weeks. We're running at rate. We haven't missed a beat in terms of customers there. We planned to head to build for hurricanes in advance, so we had stock there, just waiting for the ports to open up a little bit to ship them back out, but just to skip to that, it really wasn't in the res business for us; it was largely in the Thermo King business.

Got it. That's helpful color, Mike. Maybe my follow up here, and this is just perhaps refreshing my memory, but I thought you guys were targeting investments in the second half of the year that were roughly 2x that of the first half? So we were thinking it was going to be closer to like call it $40 million of spend in the second half. I think you did about $11 million this quarter? So should we think about the fourth quarter as being pretty highly loaded with an uptick in investments? Or are you pulling back on spend a little bit?

Well, Joe, so that's an interesting area. We are pulling back a little bit, but let me tell you how that's actually coming about because this is not Mike and I going out and saying, we need to cut investments. So I would expect the fourth quarter to be a little higher than the third quarter, but nowhere near what the math would tell you that you would pull in, it's not 30, by any stretch. But our businesses, as we get closer to actually going through the projects that are in investments, and again, our investments are mostly new product development, channel, and some IT type of investments, are actually looking at the projects and the return on those projects and they're coming to the conclusion that the returns are not at the expectations that they have and we have as a company. And so they're the ones pulling them off the table and perhaps going back to do some additional work on those business cases, and maybe they'll show up again in 2018, but it's really SBU-driven, pulling down those investments in the back half of the year, and we're very supportive of that for those reasons.

Just a question on sort of management succession. You've had some recent changes at the top. I think some have been scheduled, like Didier and Robert, but I think Gary Michel was probably not expected. Can you just tell us what this means about the operational direction of the company, this transition at the top? And what's happening with Gary's role?

Thank you, Andy. This is a good opportunity to discuss the recent changes, some of which you mentioned and others that will be addressed soon. Robert and Didier have been valuable partners to our company for many years and both had plans to retire in 2018. We started formalizing these plans in January 2017, with Robert stepping down in January 2018 and Didier in September 2018, allowing us to benefit from their contributions for a while longer. At the same time, we began planning, and on September 5th, we appointed Dave Regnery as the Executive Vice President, combining the responsibilities of the two roles. We have had strong and consistent leadership at the SPU level for a long time. We’re not in the same situation we were five years ago, and the role has evolved. I have a lot of confidence in Dave, who has spent 30 years with the company and has done an excellent job with the HVAC business in North America and EMEA, managing various parts of the company throughout his career. Along with Dave’s appointment, we moved Donny Simmons into his previous role. Many of you met Donny at our Investor Day; he previously led fluid material handling and Power Tools and managed a significant part of the Commercial North American and Trane organization. Before that, he was in finance for both the Climate segment and going back to TK. A few weeks later, Gary announced his intention to retire at the end of September. Following Gary's announcement, we appointed Jason Bingham as the President for HVAC and Supply. Jason, who spoke at the analyst conference, previously ran our Controls Contracting and Digital business, which has grown into a $1 billion-plus business over time. He has a strong commercial and residential background with a tenure of 26 years at the company, which started in 1991. Additionally, Marc Dufour, who leads our Club Car business, is also set to retire in January 2018, and we announced his retirement around the same time. Mark Wagner, who spoke at the analyst conference as well, is now running Club Car for us. This transition highlights the strong internal leadership talent, effective communication among the senior executives regarding succession plans and timing, and their eagerness to collaborate on dates to ensure continuity. We are very excited about these changes, and the new leadership has been in place for a couple of months now, creating a positive outlook.

And just a follow-up question on cost, and I apologize I'm sort of beating the dead horse here. Just so we have slightly lower spend in the quarter following lower investment spend that we're planning on. I would imagine that China and Middle East strategy, you've had that for a while, so I'm just still sort of a little bit missing why there was this earnings shortfall? Is it because sort of China and Middle East ended up being more expensive than we expected? Or is there something else on top of that below the surface that was weaker than we expect? And I apologize if I missed it.

Yes. I mean, if I put it really simply, I would say that the Tier 3, Tier 4 strategy for some of the larger infrastructure projects are carrying about 5 points lower gross margins, let's say, than the Tier 1, Tier 2 city historical applied market. And the fact that we've grown that at a rate twice the rate of the other business just put margin mix pressure there. And then again, adding 178 people into the mix, it takes a while for those people to ramp up, but again, 40-plus-percent growth rate serves the ramping up pretty quickly.

And the other element, Andrew, is that Asia, China specifically, has had material inflation that has escalated throughout the year. So when we talk about that being persistent, it is very persistent. In fact, if I looked at where the biggest impact occurs, it's our Commercial HVAC in North America, followed by Asia-Pacific, followed by Residential. So they've also had that headwind that was bigger than what we thought earlier in the year, and that also contributes to that dynamic.

This is James Picariello, actually. So just on M&A, you mentioned $200 million commitment year-to-date. It looks like only $60 million has actually been spent. So is it safe to assume that the telematics asset represents most of that difference? And then also, how do you bridge to this $400 million to $500 million range? What's the timing between an actual agreement and the close of a deal? So just trying to get a sense there.

Yes, James, I think we closed four transactions or will close four transactions by the end of the month. So I wouldn't assume it all to be in the telematics space, so that would have been the larger of the group, but a couple of hundred million is really laid out, and we'll have that closed by the end of the month. The balance of that is our best guess of stuff in flight, of which I would say between $50 million and $200 million, there's a number of things in flight there that the timing could be off slightly, it could be a quarter off here or there. But those are lining up nicely as well too, and it ranges between channel and technology being added to the core portfolio.

Okay. And then just one last question about the residential HVAC replacement opportunity. How have previous storms affected that demand, and typically over what time frame? I'm trying to gather your initial thoughts on what the opportunity might look like next year and perhaps even further ahead.

Yes, the commercial side is somewhat easier to predict than the residential side. In commercial, we can anticipate a significant rental surge, which is often followed by an immediate need for services. We allocate resources to those locations to provide service from out of state. When it comes to the specifics of what we're preparing spaces for, the urgency varies. In the residential sector, there is a wide range of situations. On one end, there are individuals with insurance who can quickly make decisions, while the broader group may be waiting for insurance claims, which can be a lengthy process. We are currently in a situation similar to 2018, where some individuals lack insurance and might not be able to make purchases right away. This can take one to three years to stabilize. Generally, over a period of one to two years, we expect to see growth as a result of these factors, particularly in the residential sector. The growth tends to manifest over a longer timeframe compared to the quicker responses seen in the commercial sector.

Great. Thank you. I'd like to thank everyone for joining today's call. As usual, we'll be around to take any questions that you may have today or over the coming days. And we look forward to seeing many of you on the road in the coming weeks and into 2018. Thank you.