Trane Technologies plc (TT) — Q3 2018 Earnings Call Transcript

Thanks, operator. Good morning, and thank you for joining us for Ingersoll Rand's Third Quarter 2018 Earnings Conference Call. This call is 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 our 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. Joining me on today'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. Mike?

Thanks, Zac, and thanks, everyone, for joining us on the call today. Please go to Slide 3. I'd like to begin with a brief review of the fundamental elements of our business strategy that underpin our quarterly results and create value for our shareholders. First, our global business strategy is at the nexus of environmental sustainability and impact. The world is continuing to urbanize while becoming warmer and more resource-constrained as time passes. We excel at reducing the energy intensity of buildings and industrial processes, reducing greenhouse gas emissions, reducing waste of food and other perishable goods, and we excel in our ability to generate productivity for our customers, all enabled by technology. Our business portfolio creates a platform for the company to consistently grow above-average global economic conditions, aided by the strong secular tailwinds I've outlined. Second, our business operating system is designed to excel at consistently delivering strong top line growth, incremental margins, and free cash flow. And lastly, over the years, we built an experienced management team and a high-performance winning culture that makes our performance sustainable. And combined with our dynamic capital allocation strategy, we have a differentiated business model that drives strong shareholder returns over the long term. Moving to Slide 4. Exiting Q3 and moving into Q4, we continue to execute well and are on track to exceed the guidance we outlined for investors on our Q2 earnings call. First, our end markets remain healthy, and we have continued to deliver excellent growth in bookings and revenues in both our Climate and Industrial segments. Additionally, our growth continues to be broad-based across virtually all businesses, products, and geographies globally, and services growth continues to be especially strong. Second, our leverage and profitability are improving as we are effectively managing all elements of the P&L to deliver results. In the third quarter, we achieved our second half 2018 leverage target of approximately 25% through strong volume and effective management of our price versus material cost and productivity versus other inflation metrics. We saw good margin expansion across the business, led by the Industrial segment and healthy margin expansion in our Commercial and Residential HVAC businesses. The second half of the year has become increasingly inflationary since we updated our guidance in July. We are embedding the impacts of additional material and other inflation, tariffs, and their knock-on effects into our forecast. In spite of this impact, we expect to continue to effectively manage these costs as we have in the second and third quarters and to maintain our guidance of approximately 25% leverage for the fourth quarter. We have raised our full year adjusted earnings per share guidance to between $5.55 and $5.60, up from approximately $5.50 for fiscal 2018. In October, our Board of Directors approved a new share repurchase authorization of $1.5 billion, bringing our total available authorization to approximately $1.9 billion. This reflects continued confidence in our ability to generate strong free cash flows going forward and gives us increased capacity as we execute our dynamic capital allocation strategy. 2018 is shaping up to be another strong year for us. As we move through the fourth quarter, visibility into 2019 is also improving. Based on virtually everything we're seeing, our major end markets look poised for another year of good growth. Strong bookings in 2018 are also setting us up with a solid backlog picture heading into 2019. And finally, we're managing material and other inflation and tariffs, enabling us to drive solid leverage through the P&L and further expand margins. We expect to use the same processes and tools in our business operating system to manage these risks in 2019. In summary, we're executing our strategy well and this is enabling us to deliver differentiated performance in 2018. The second half is progressing consistent with our expectations and we plan to close out the year on a strong note. Looking forward to 2019, we're expecting another good year for our industry and particularly for Ingersoll Rand. Please go to Slide #5. The third quarter was highlighted by continued strong growth across the board as indicated by the positive signs on the chart. Enterprise organic bookings and revenues were both up double digits. Climate led the way with organic bookings and revenues of 12% and 10%, respectively. Industrial was also robust with organic bookings and revenues up 7% and 9%, respectively. These results reflect continued strong execution of our business strategy, capitalizing on healthy end markets. The one minus on the chart was a bookings decline in Commercial HVAC in the Middle East, where orders can be lumpy and there were a couple of large orders in the third quarter of 2017 that did not repeat in 2018. European HVAC orders continued to be strong in the quarter. Let's go to Slide #6. The next two slides provide insights and additional color into the key drivers behind the chart on Slide 5 and how we're thinking about the markets for the remainder of the year and into next year. In Commercial HVAC, we're seeing sustained growth globally in both bookings and revenues with good growth in both services and equipment. North America growth was strong with continued gains in services, contracting, controls, and equipment. Institutional growth was particularly strong, led by the education markets. As we discussed on Slide 5, Europe Commercial HVAC remained strong with solid growth across the board in both services and equipment. China HVAC growth continues to outpace the market. Weakening economic indicators in China did not appear to be impacting the HVAC markets to date. Other markets in Asia continued to be mixed, as they have been all year. Our outlook for global Commercial HVAC remains healthy and key economic and market indicators largely support our view with increasing visibility into 2019. Turning to Residential HVAC. Bookings and revenue growth continued to be strong. Replacement markets, where the majority of our sales are derived, should continue strong growth in the quarter, and this is expected to continue through the remainder of 2018 into 2019. Please go to Slide #7. Our Transport Solutions business continues to be globally diversified and resilient. We've seen good order growth for North America trailers in 2018, and the estimates for market revenues have improved from the beginning of the year as well. The Americas Commercial Transportation Research Co., also known as ACT, has taken their forecast for North American refrigerated trailer shipments to 43,700 units, which represents approximately 3% growth over 2017. Our capacity to ship refrigeration units exceeds the industry capacity to supply trailers, so we should have solid backlog heading into 2019. Auxiliary power unit growth was strong in both refrigerated and non-refrigerated segments. As with North American trailers, backlog will be strong going into 2019 as well. Overall, the transport markets remain healthy in 2018, and we expect this to continue heading into 2019. Compression Technologies growth has been solid, consistent with industrial production and other key leading indicators. In Quarter 3, we delivered good growth in bookings and revenues in both aftermarket and equipment, with particular strength in China. We are seeing some signs of pause with our large Chinese exporter customers as U.S.-China trade negotiations continue and Chinese economic indicators weaken, but it's too early to call what impact this will ultimately have, but we're continuing to monitor the situation carefully. Overall, we expect to see solid growth broadly across key products, services, and markets through year-end and into next year, while maintaining optimism that the U.S.-China trade negotiations will come to a favorable resolution. Small electric vehicle bookings and revenue growth were strong, driven largely by continued success of our consumer vehicle. We're also seeing strong growth across our high-margin Industrial Fluid Management, Tools, and Material Handling businesses. Now I'd like to turn over to Sue to provide more details on the quarter. Sue?

Thank you, Mike. Please go to Slide #8. As Mike highlighted, Q3 was another strong quarter for us with continued robust bookings and revenue growth, improved leverage, solid margin expansion in both our business segments, and 22% year-over-year adjusted continuing earnings per share growth. The third quarter was right in line with our expectations regarding how the second half would play out when we provided our updated guidance on our Q2 earnings call, which gives us confidence we'll continue the trend and achieve that guidance with $0.05 to $0.10 of upside on the EPS line or a revised adjusted earnings per share range of $5.55 to $5.60, up from approximately $5.50. Looking at our third quarter results in more detail. Bookings and revenue performance remained strong with sustained growth in virtually every major product category and geography. Services was, once again, a standout with 11% growth, outpacing 9% equipment growth as we continue to focus on our growing mix of stable, high-margin recurring revenue streams. We continue to target free cash flow equal to 100% of adjusted net income for 2018. Year-to-date, we've been able to sustain very high levels of revenue growth across the business at 9% organic for the enterprise. We've been able to maintain this growth, in part, because we've appropriately raised our inventory levels to keep up with the robust demand for our products and to meet the needs of our customers. As a result, we're sitting at a higher working capital level at just over 5% of revenue. This is consistent with 2017, and we expect this to improve as we return to a more natural 3% to 4% level for us in the fourth quarter. We maintain our commitment to a dynamic and balanced capital allocation strategy and to returning 100% of excess cash to shareholders over time, whether it be through our strong and growing dividend or through share repurchases as we've consistently demonstrated over many years or through value-accretive M&A. Through September, we have returned over $850 million to our shareholders in the form of dividends and share repurchases. In October, our Board of Directors also authorized an additional $1.5 billion share repurchase program, bringing our total available share repurchase authorization to $1.9 billion, demonstrating our commitment to share repurchases as an important element of our capital deployment strategy and giving us good flexibility on how and when we execute the program. We also continue to have a healthy and accretive acquisition pipeline that presents opportunities for value-accretive M&A. Our year-to-date spend is approximately $280 million. This spend is primarily related to the ICS Cool Energy acquisition and the Trane-Mitsubishi JV. Both acquisitions are performing well and ahead of our initial value-creation models. Please go to Slide #9. As we've discussed, Q3 was a strong financial quarter from top to bottom. At the enterprise level, we delivered 10% organic revenue growth, 100 basis points of adjusted operating margin improvement, and adjusted continuing earnings per share growth of 22%. Importantly, we also achieved operating leverage of approximately 25%, which is improvement versus our leverage of approximately 19% in the second quarter and consistent with our guidance for the second half of 2018, as we continue to manage through increasing inflation, new tariffs, and other inflation in areas such as freight and wages. Please go to Slide #10. Focused execution of our strategy in Operational Excellence drove strong core business operating income contribution in both of our business segments, which combined for approximately $0.28 or virtually all the earnings per share growth in the quarter. The quality of earnings for Ingersoll Rand remained high and that we had a very clean quarter with strong results across the board. Please go to Slide #11. Strong execution drove 100 basis points of adjusted operating margin improvement in the quarter. Price versus material inflation was positive by 10 basis points. Productivity versus other inflation was flat. We're effectively managing tariffs, material cost increases, and other inflationary impacts consistent with our guidance for the second half of 2018. Please go to Slide #12. Our Climate segment delivered a very strong third quarter, with 10% organic revenue growth and 50 basis points of adjusted operating margin improvement. Results were strong across the board, consistent with our expectations. Please go to Slide #13. Our Industrial business also delivered very strong results with 9% organic revenue growth and 190 basis points of adjusted operating margin improvement. Similar to Climate, the strength in the business was broad-based, and it was a very clean quarter. We continue to see strong leverage in our Industrial segment driven by commercial improvements, restructuring returns, and productivity improvements. Please go to Slide 14. We remain committed to a balanced capital allocation strategy that consistently deploys excess cash to the opportunities with the highest returns for shareholders. We maintain a healthy level of business investments and high ROI projects, which is helping to drive our strong growth in both our Climate and Industrial segments this year. As we've discussed on prior calls, in 2018, we have also increased our capital expenditure investments primarily related to a number of footprint optimization initiatives and new product development projects. These investments will help us make a more cost-efficient and resilient business. We maintained a strong balance sheet with significant optionality as our markets continued to evolve. We maintained our long-standing commitment to paying a strong and growing dividend at or above net income growth. We continue to invest in share buybacks when the shares trade below our calculated intrinsic value. And as noted earlier, our Board of Directors approved a new share repurchase authorization of $1.5 billion in October to a total available authorization of approximately $1.9 billion. Year-to-date through Q3, we returned over $850 million to shareholders in the form of dividends and share buybacks. Please go to Slide 16. One of the main topics of interest is how we are managing tariffs and inflation. We've discussed this topic a fair amount throughout our remarks, so I won't spend a lot of additional time on the topic here. This slide gives a good summary of how we are managing all of the associated cost risks, so we've included it in the presentation for your reference. Please go to Slide 17. A second topic of interest is our visibility into 2019. As Mike highlighted earlier in the presentation, as we move into the fourth quarter, our visibility into 2019 is improving. We expect to continue to have healthy end markets, and our business portfolio creates a platform for the company to consistently grow above-average global economic conditions, aided by strong secular tailwinds. Strong bookings in 2018 should also set us up with solid backlog headed into 2019. We're factoring in the expected impacts from inflation and tariffs into our planning process for 2019, and our objective is to effectively manage these impacts by managing the whole P&L to drive solid leverage as we've done in 2018. We plan to provide full 2019 guidance when we hold our fourth quarter 2018 earnings call in late January. The last topic is restructuring. We have updated our full year 2018 guidance for restructuring cost to $0.28, up from $0.20, reflecting recently announced initiatives related to the company's ongoing footprint optimization, which drives operational efficiencies and reduces cost. Now I would like to turn the call back to Mike for closing remarks. Mike?

Thanks, Sue, and please go to Slide 18. We believe the company is extremely well positioned to deliver strong shareholder returns over the next several years. Our strategy is firmly tied to attractive end markets that are healthy and growing profitably. Our products and services portfolio is at the nexus of global energy efficiency and sustainability megatrends, which provides a tailwind for growth in above-average economic conditions over the long term. Unless you believe the world is getting less populated, cooler and less resource-constrained, these secular megatrends will continue to create growth opportunities for Ingersoll Rand. We have an experienced management team and a high-performing team culture that incorporates Operational Excellence into everything we do. Our business operating system and our culture are a differentiated and sustainable competitive advantage. And lastly, our business model generates powerful cash flow and we are committed to dynamic and balanced deployment of capital. We have a strong track record of deploying excess cash to shareholders over the years. And with that, Sue and I will be happy to take your questions. Operator?

I was wondering if you would help us out a little bit more with tariffs. I understand that it's included in your guidance, but specifically thinking about this list 3 at 10%. Can you give us some idea of what kind of headwind you are overcoming there? And obviously, the follow-on thought, obviously, is then you're going to think about what that means if we do go to this 25% and how you take actions against that.

We showed everything we know on list 1, 2, and 3 and 232 combined, would have been a headwind for 2018 of around, say, $30 million, probably a little bit less than $30 million, but close to $30 million. And in 2019, it would be an incremental, say, $80 million. And our view toward that has always been we're going to cover material cost with price. We're going to cover productivity, productivity over other inflation. So we did that in Q2. We did it in Q3. We think it's flat in Q4. Price is still building through the system, and you're seeing that, and we'll see it through any of the engineered systems that we produce in the company, whether it's HVAC or air compressors into 2019. So I feel like we've got a handle on it, managing the impact of that. Handle that with the strategies that we've had, historically, in the company over the last few years.

Great. And then, separately, there's been a lot of talk about consolidation and the like in the industry. I just wondered if you could update us on your thoughts on what your priorities are whether you think the market's ripe for such a move and what exactly you'd be looking for.

Our views haven't changed over the last few years, which would be fundamentally at the heart of that. We're in great shape strategically. We don't need to do anything. So anything that we would do, we need to be very compelling from a shareholder's point of view. Having said that, we played all the game theory that's imaginable on this and clearly know sort of what would make sense for us competitively and how we'd react to all of the above. So on that, there's really nothing more to kind of add on that at this point in time.

I wanted to follow up on Jeff's question to clarify our position. For this year, overall, the price material inflation seems to be slightly negative. We've seen a negative impact of 40 basis points in the first quarter, and it appears to be relatively flat for the remainder of the year. Is that the correct assessment for the year?

Yes. Fundamentally, it was flat for the back half of the year. That's where we think we're going to track as flat to the back half of the year.

Yes. So I guess, just thinking about that $30 million from tariffs alone, there was obviously some pretty substantial just base inflation that you guys are covering with what, like 1.5% of price this year, something like that?

Roughly.

So that $80 million in the context of what was in total inflation. Obviously, a much bigger number than the $30 million of just the tariff-related stuff in 2018, and arguably maybe that stuff is not as severe on a year-over-year basis in 2019. Is that the correct way to look at it?

It is, Steve. I think, again, the pricing that we've put in is what contemplated all of this. If anything has changed, it's been a little bit more around some of the retaliatory approach that China has taken to some of the U.S. imports. I think we've got a strategy to deal with all of that within the planning process. If we had perfect information on input costs for 2019 or if costs didn't change from this point in time, we would target the same 20, 30 basis points of margin expansion price over material inflation that we normally would put into effect in the planning process. I believe that, that's where we'll land in 2019.

And Steve, one other...

Yes. Including the $80 million? Including the $80 million, correct, that you just talked about what you know today?

Exactly. Absolutely.

Okay. Sorry. Go ahead, Sue.

That's right. So I just wanted to point out that if you are looking at the total impact on Ingersoll Rand, the dollars that we're talking about is just under $30 million and the $80 million are from the Section 301. So there's also the Section 232 impact that we build in, in the July guidance which was about $38 million in 2018 and it's roughly $20 million for 2019. So I don't want to lose track of the fact that we were also trying to overcome the Section 232 piece of that in our pricing and our other mitigating actions for the price material cost equation.

Yes, I want to clarify that everyone is aware of the $80 million. I understand the overall dynamics because you successfully covered a lot more than that in 2018, and pricing remains strong. One more quick question: regarding productivity and inflation, you've mentioned it has been weak year-to-date, but that you anticipate significant improvement in the fourth quarter. What is driving that improvement, and can we expect it to continue into 2019?

Yes. Steve, that's a good point. First of all, thanks for the clarification on the $80 million support. People know that we're covering that, still expect to get 20, 30 basis points net of 232, 301, and all of that. As it relates to productivity, it's been the same discussion all year long, which is just the way that productivity projects will load into the year to be a substantial increase in the fourth quarter. Some of these were larger footprint moves or complexity reduction projects across the company that really bear fruit in the fourth quarter. So it is a step up in the fourth quarter. Those projects are underway. They're implemented. They're defined. It's a pipeline. So it's not that we're hoping that productivity comes into the fourth quarter. We've got the projects that support that estimate.

Can that carry into '19?

Well, we haven't done '19 yet. But the key with '19, just like price material inflation, what we'll do from a pipeline perspective is look at productivity offsetting all other inflation, anticipating wage inflation, anticipating logistics pressure, anticipating all the 232 stuff coming in still. We'll cover that through productivity. If you go back, again, in the operating system of the company, the question we ask ourselves is do we have 125% of what we need to do in the pipeline primed and ready for 2019. And that will be sort of the emphasis here as we exit the year is making sure the health of the pipeline is going to be that 125% which, historically, is what we've done and what we think we can continue to do for some time and in the future.

Nice to see the progress, everybody.

Thanks, Steve.

Maybe just going back, I want to just clarify, that 25% operating leverage that you're getting this year, that is inclusive of that flattish price material inflation in the second half or not?

It's all in, Steve. So we're saying that for the back half Q3, Q4, 25% is a good number and that's mitigating anything kind of coming in.

Okay. Great. And maybe just on that $80 million that you just referenced and those headwinds, can you talk about the base that that's on? In other words, maybe just putting that in context of the actual China kind of import volume or dollar volume to the U.S.

Yes. Steve, probably not on this call. I mean, going to that detail because we have to separate a lot of what is more opportunistic supplier pricing coming in from what's a direct tariff. It's a very difficult analysis to make. At the end of the day, the analysis of that isn't so important as to know sort of what we think sort of the right numbers should be and then how to offset that with productivity and price. So it would be difficult to pull out in a call and give you anything reasonable.

Okay. Fine. On the residential growth side, are you noticing any direct benefits from other suppliers facing challenges in their supply chains? Can you quantify whether that is significant for your company?

Yes, we don't discuss our position relative to any other competitors, but it's evident that for the past four years, we have experienced significant share gains and margin growth in the Residential business, which continued this quarter.

Maybe just trying to stick to two questions. The first question just on the incremental margin point. You have more productivity in Q4 but you're saying the incremental margins stay in the mid-20s consistent with Q3, so just wondering what's moving there. And allied to that, are 25% incrementals the right sort of level for the current macro environment as you look out with high tariffs, high cost inflation, high volume growth?

Let me do the second part first, and Sue might come back on the first part. But I think with the volatility of the environment we're in today, we've always said that we think that incremental margins should look like gross margins, but we always guided you all to think about that as sort of 25%, allowing some room for breakage, allowing some room for investment in the business and all the things that create a healthy business for the long run, and that's what we're saying here. So I do think that leverage could go higher, particularly if we saw larger compressors kind of coming back in 2019, as an example, continued mix toward services being higher than equipment. That's certainly support of higher levers as well. But I think with the environment and the volatility we're in, 25% incremental is pretty good performance. I think it's really good performance. And I think that, that is something that we're committed to for the back of the year.

And Julian, on the other side of that, with the first part of your question, it's interesting as we go through the fourth quarter and all of the pieces that you see. So our pricing was, in effect, as we went through the guidance in July. We are adding in the impact of the additional tariffs that we didn't know in July when we gave that guidance. So you have a little bit of impact there. You have some additional productivity. But the other part, when we think about the overall bridge and those overall incremental margins, we're also continuing to invest in the business. And when I look at fourth quarter spend, we're not trying to cut back any of those good investments in whether it's new products or whether it was in the footprint in the fourth quarter, and so we've got some good investment spend also in the fourth quarter. Again, it's not an outlier compared to other quarters in the year, but it is slightly higher, and we are continuing to do that throughout the year.

And then my second question would just be around Industrial segment demand. There seems to be more question marks around the sustainability of the backdrop for it. It sounds like though the only weak spot you have seen is some of those Chinese exporters around large compressors. If you could just confirm that's the case or if there are any kind of watch areas that you're focused on.

Yes, Julian, I'll address your question and provide some broader insights on China to give you an understanding of our perspective. We're trying to align our thoughts not just with our own customers, but also with other companies reporting their earnings. The Industrial business and the HVAC business are currently very different landscapes. China is focused on clean air and clean water, and considering that 15% to 25% of all greenhouse gas emissions are linked to HVAC and buildings, combined with transport refrigeration powered by diesel engines on trailers or trucks, as well as process cooling and air compressors in industrial factories, there's a clear opportunity in anything related to clean air, clean water, and retrofitting the economy and built environment in China. This could create a positive business outlook that may differ from the narrower industrial economy. Regarding the industrial economy, we're observing some trends prior to bookings—this involves the pipeline and our communications with customers. Chinese customers who previously relied on a U.S. export model are pausing to assess the future regulations and their viability in the long term. However, we expect these customers will eventually redirect their supply to other markets globally, which is an inevitable shift. Currently, there is a pause in the export model from China to the U.S. due to ongoing negotiations about tariffs. We anticipate that this may have a short-term impact, but these customers tend to make quick decisions when opportunities arise, so the situation can also change positively in a short timeframe.

Just to disaggregate the Climate bookings a little bit in Q3. First, do you still think that Q2 had a pull forward of about $80 million to $100 million? And how much did price contribute to the 10% bookings growth organically in the quarter?

Our pull-through estimate wouldn't have changed there. It was just really strong across-the-board bookings, and you really can't find a soft spot. The only one that showed up on the chart was a little red dash, which happened to be the Middle East off a really tough comp. But everything is extremely strong, whether it's Residential, Transport, Commercial across the world. If you pull apart Commercial and look at Applied versus unitary versus services, everything is strongly in the green there as well. So the color is good. If you go around the world, I mean, you're seeing nice recovery in parts of Latin America for us. We're seeing, of course, outperformance in Asia Pacific, particularly with what we're doing in China. So all those things are contributing to a strong growth rate, but it's across the board.

Okay. And price on a net basis in that number, the 12%?

Yes. So price remains strong in Climate, I mean, across the board. Of course, the short-cycle inventory in Residential or in light commercial, very quick there to have price effectivity. On the applied engineered systems, that's still building through the system. Of course, it's going to be shipping well through 2019. At this point, we built considerable backlog there as well as building several backlog in the trailer market, North America, and in the auxiliary power unit market for North America. So I think when those products ultimately ship in 2019, you're going to see more price carried forward there as well. But price effectiveness in Climate is the strongest I've ever seen it.

One follow-up on your comments on consolidation and just I noticed you underlined balanced allocation of capital on Slide 4. Mike, should we expect that large acquisitions aren't really part of the plan here? It's going to be more of what you've been doing, sort of the tuck-ins? Or do you see any case for something larger to actually unfold?

Yes. The main point to emphasize is that we are maintaining our long-standing methodology and discipline concerning capital allocation. We tend to see the highest and quickest returns on invested capital when we invest organically in the business, which is reflected in our historical share and margin expansion. We believe that dividends should grow in line with net income over time, and we are committed to ensuring that investors see this reflected in our dividend announcements. We aim to control dilution, which will involve some level of buyback. Ultimately, we evaluate the available pipeline, and if we can achieve returns that exceed our weighted average cost of capital, we are creating economic value for the company, and we will remain disciplined in this regard. We have repurchased about $6.5 billion or 150 million shares since 2011, which has been significant for us. Our focus is on creating long-term economic value through capital allocation, and we will continue to do this as we have. Smaller, bolt-on acquisitions are certainly easier and less risky. As for larger, transformative deals, if an opportunity arises that is compelling from an investor's perspective, we would consider it, but right now, those discussions are hypothetical and not particularly useful for us to delve into.

This is Breindy on for Josh. You mentioned that you've been gaining some share in Residential, and we know that one of your competitors had a recent outage that would require some share shift in the industry. Is that part of where the share gain came from? And given that it should be a greater impact in 4Q, is that included in your current guidance or could we see some upside on share gain there?

Yes. About four or five years ago, we revamped most of our residential product line and entered the entry-level price point. We also adjusted our channel structure to ensure we have a product for every home and a channel partner for each product. This has contributed to our long-term growth in market share and margin expansion. We prefer not to discuss the specifics regarding our competitors and market share shifts, as we believe it's better for our shareholders to keep that information confidential.

This is Bhupender here, sitting in for Nigel. Can you guys hear me?

Yes. We hear you. Go ahead.

Okay. This is Bhupender here for Nigel. So just wanted to focus on, I think, Sue mentioned about the service strength here in the quarter, 11%. Could you give some color from what actually is driving that growth in services, especially the contribution from digital and some software initiatives you actually have in place?

Yes, it's a strategy we've been implementing for a long time to enhance the company's service mix. Historically, about a decade ago, services represented around 30% of the company, whereas today, our service-related sectors like HVAC, Commercial, and Industrial air compressor businesses are closer to 50%. Overall, we're in the 40s as a company. This strategy has been a long-term effort involving various elements. It includes our channels, direct footprint, and investments in people, systems, and tools, especially given the challenge of finding individuals with the necessary technical skills. Our investments in technology have been beneficial, allowing our teams to interact with more customers and manage tasks remotely. The diagnostics work supported by connected buildings and equipment has been particularly advantageous. Additionally, we're seeing positive responses to our different value propositions that utilize data and analytics to enhance building performance and industrial processes. One of our fastest-growing metrics is the number of connected buildings or assets, which keeps increasing by 500 to 1,000 each time I report it. This aspect of our investment continues to be robust. While we refer to it as digital, it encompasses more than just that; it's about the entire connected experience.

That's great commentary. I wanted to follow up on the visibility for 2019. When you look at the backlog, can you comment on how the Commercial HVAC backlog looks by geographical regions? Essentially, what are the changes as we move forward?

Yes. It's record backlogs coming in. What you see here is sort of institutional backlogs that are very strong, that are continuing. We've talked in the past about large projects flowing through. It's interesting that the numbers that we've been reporting all year haven't actually included any what we would think to be large projects. These large projects are still out there. We still think they're in scope for even this year, let alone 2019. That starts to set up very long-term visibility into '19 and potentially even to 2020 on some of these larger projects. So backlog there is great. Thermo King, it's pretty clear that the industry is undercapacitated for trailers and for tractors. The demand is there. So as soon as a tractor needs an APU or a trailer needs a refrigerated unit, we're ready. We're able to meet that demand. So that's a definite backlog build going into 2019. And then large compressors, we'll wait and see what happens here for the balance of the year. We're coming off a tough comp quarter 4 of '17 as it relates to large compressors, but we'll see how that plays out. But that gives us great visibility into '19 as well, this large engineered compressors that we sell.

I have a question regarding the large compressor you mentioned. I would like to understand the China industrial compressor business better. Do you believe that the margins for the fleet will be similar to the fleet average, or do you expect them to be at the segment average or lower? I'm trying to get a sense of this.

They are performing well, generally above average. China plays a crucial role in our Compressor business and in the global compressor market. Approximately half of the world's air compressors are sold in China, making it essential to monitor the situation there. The capacity being developed in China will be allocated somewhere, potentially along the One Belt One Road initiative, which could align well with where that capacity might be directed. Customers in this market are proactive and tend to make swift decisions, so the capacity will indeed be utilized. However, I want to caution that there might be a temporary slowdown in this business in the short term.

I want to take a moment to reflect. Clearly, the market has perceived some challenging factors over the past month or so, yet you have delivered an impressive quarter, potentially one of the best I've ever seen. How do you explain the stark contrast between the fear evident in the significant decline of homebuilding stocks and the overall healthy environment you are observing?

When you consider the markets we serve, around 15% to 25% of the world's greenhouse gas emissions are associated with HVAC systems and buildings. We launched technology two years ago in the applied space that can eliminate greenhouse gas emissions by 99.9%, which is a significant opportunity. For instance, trailers using a refrigeration cycle powered by a diesel engine can be electrified, also reducing greenhouse gas emissions by 99.9%. In industrial plants, we are positioned to support efforts to lower these emissions. It’s important to recognize that we aren’t just another industrial business selling machinery; we are involved in exceptional sectors with differentiated technology, channels, and service models. This presents a compelling long-term story. We hope that investors see the current market disconnect as a favorable entry point into a company like ours, which has strong businesses and a proven track record of executing well with smart capital allocation to support our growth.

It's a fair point. And again, just to back up a little bit. I mean, do you get a sense, Mike and Sue, that it's easier to get price out there now than it has been in the past? I mean, partially just because of the front page news, the tariffs have been and maybe, partially, just because of the answer you just gave, just some differentiated technology. I mean, does it feel easier to you guys at least or seemed easier because you seem to catch up to the price cost curve pretty quickly?

When considering engineered systems, such as large supply systems or air compressor systems, it’s important to note that just 10% of the total life cycle cost is from the initial purchase price, while 90% comes from energy, maintenance, refrigerants, and other ongoing expenses. It’s advantageous to present a value proposition that highlights efficiency benefits and refrigerant advantages to justify pricing. However, as we move towards more commodity products like residential HVAC systems with standard SEER levels, operational excellence becomes crucial. Having the best dealers, technology, and cost-efficient operations is key to thriving in this environment. There are varying pricing models, but being able to stand out through technology offers a distinct advantage.

Mike, so I think you mentioned last quarter that the Chinese HVAC market you sell is growing in the 5% range or so and that Ingersoll is growing in multiples of that. From what you could tell, is the market still growing at close to that rate? And have you been able to actually accelerate your outperformance in that market given you now have, obviously, the direct service model in place for a while, but you also talked about that service pull-through beginning to kick in?

Yes. Over time, you will notice that the HVAC sector and the built environment in China may differ from the industrial economy in relation to the tariff discussions. The built environment in China is significantly larger than that in the U.S., and much of it was constructed without adhering to the highest codes, standards, or efficiency levels. This creates vast opportunities for retrofitting to enhance efficiency and improve air quality. Therefore, I believe this will be a strong market for a long time, regardless of the state of the industrial economy. This perspective guided our strategy and investments from last year, and we are pleased with our progress. We are seeing impressive penetration into the equipment sector and high linkage rates with services, which gives us confidence that our strategy was correct and that it is unfolding more rapidly than we anticipated. I am optimistic about our developments in this area, and I believe we will continue to excel in China specifically.

Maybe a similar question, North America institutional HVAC. So when you look at that strength, obviously, some of the strength is just the market itself. But could you give us some more color on your performance of the markets in the sense that I know you do performance-based contracting, your digital capability on these big applied jobs has improved. So has penetration there actually accelerated versus the market? And so as you look into 2019 and '20, that's what sort of results in this good visibility because you're really going to outperform the market based on what you see.

Well, I mean, again, if you think of $4.5 billion, $5 million of Commercial North American HVAC business and you split it and set half of it service and half of it is equipment, the equipment, 85% of that is going to be replacement. It's a real opportunity to go create demand around the installed base and go create demand around energy efficiency. What you're finding now, in addition to that, is the institutional cycle started last year probably in earnest, still I think relatively early to mid-cycle in that. And then some of the larger projects tend to happen later in the cycle as it relates to larger campus environments, larger customers that have got more complex solutions to put in place, take more time to kind of get that designed, engineered, and implement it. And so I think we enter that phase here in the next year or two.

This is Evelyn Chow, for Joe. Let's begin with the Industrial incrementals, which have shown good progress throughout the year. The mix of bookings with large compressors and service appears to be growing, and it looks like you're achieving better pricing. What are the factors that could lead us from the mid- to high-30% incremental range we're experiencing in the third quarter down to the 25% figure we've previously mentioned for the enterprise?

Industrial leverage is currently in the high 30s and will maintain that level into the fourth quarter. The company is performing well at both the operational and service levels, and they are making significant investments in the business. These investments have been substantial, especially as they work to upgrade their product portfolio this past year. They are building for long-term success, and I believe that leverage will exceed 30%. We expect this trend to continue into 2019. Additionally, we have noticed that when larger compressors return to the market, they usually provide us with very high leverage due to the larger fixed costs we have established.

That's great, Mike. And then maybe just turning to the $80 million of tariff-related inflation and ways that you might mitigate. Is there any thought on potentially pre-buying some of your inventory instead of letting working capital normalize into 4Q? And then maybe as an addition to that, Sue, if you could provide us any color on how much metal spend you either bought or hedged into 4Q in 2019, that would be great.

I think every time we look at sort of fundamentals of lean versus pre-buying lots of inventory, it comes down to you want to really run the business as lean as possible and you want to make sure supply chain is as short as possible. It tends to favor suppliers that are more localized than sort of long-distance suppliers. And so I think we continue on the journey that we've been on around lean throughout the company and look at that. The supply base is an extension of our lean efforts there. So Evelyn, on that front, I don't see us doing any pre-buys other than where there's constraints in the industry. So if there's a constraint around semiconductor boards or circuitry or a constraint around diesel engines, those are places that we buy or had to make larger commitments. But for the run-of-the-mill stuff we buy and the bill of material, we will continue to run that in the leanest way possible.

Yes. And Evelyn, I think when you think about our strategy around purchasing materials and all that and the impact of 2018 and 2019, we're obviously doing buys each and every quarter for not only the commodities but to move the Tier 2 component. So if you think about 2019, I would say that you might be 50%, 60% bought or committed for the first half of the year and then less so in the second half of 2019. But I think the more important piece of how we buy, whether it's the commodities or some of our other materials, is I don't think you'd want to assume that because of where things are today that you would go and buy that even if it meant that you were slightly higher percentage of revenue. And why I say that is the tariffs and the whole discussion around inflation is a really volatile equation, and you could find yourself buying because you think it's a great idea, and then all of a sudden maybe something goes away or speculation comes out of a commodity, say, copper, and you have a lower price. I think you're better off following a routine, following a process and layering in your materials as you go throughout the year and making sure that you have the right sort of blended rate for the materials that you're buying in, and that's exactly what we do as we think about that. And my comments around working capital and where it goes, the 3.5% to 4% is a really natural level for us to really be able to support on-time deliveries and to support our customers. So while it comes down from Q3 to Q4, it isn't because we're unnaturally forcing it down. That's really just the normal cycle of inventory for us. So if there is an opportunity to have something that would be different, we'd certainly look at that. But I really think that ratably buying and following our natural processes is the right way to go.

So definitely a lot of ground covered. And I just want to make sure I understand or maybe put a finer point around the visibility into '19, but we've talked about applied backlog being stronger, service growth, what's going on in Industrial around compression. Is there a way to quantify the better visibility you see into '19 as of today versus maybe historically or even last year? It would feel like you would have more visibility just given the way the dynamics are playing out than you've historically had into '19.

Well, I mean, by virtue of the service business, being what it is, I mean, you get more visibility because you have to believe service is going to continue. And in fact, if there's a downturn, you're going to see service go up as people extend asset life. So I would think that service growth, as it relates to visibility, is a better way of thinking about the mix over the long run. That helps. And then if you take sort of the equipment and systems businesses, nothing's really changed there other than the fact that you can see the backlogs building and you can understand from a correlation of the metrics that we use to establish the demand forecast, that they still tend to be favorable. So between what's in the backlog, what's in the pipeline, and the metrics that are before the pipeline, that would be the leading indicators that we use. And there's different indicators for different businesses and different segments of the business and products even in the business. We're able to feel good about '19 at this point shaping up. Unless it's a dramatic geopolitical event, a dramatic event that's not seen today, we feel like 2019 is shaping up to be a good year.

And then as we think about the energy retrofit business in the U.S., obviously, that's driven by replacement, the age of the assets if it breaks, energy code or new regulations. But are you seeing any changes around customer demand due to new financing mechanisms as new money enters that market to fund some of these upgrades? Is that helping drive some of this growth or is that not something you're seeing at all yet in the market?

No, the vast majority will come from traditional customers financing their own deals, along with performance contracting, which is suitable for institutions that may not always have the capacity. This is an asset that institutions possess that can yield a return. When considering the assets institutions typically hold, buildings are significant. It's noteworthy that utilities and maintenance costs often comprise the largest portion of their operating budget. Therefore, they would likely utilize financing in various areas and rely on performance contracting to address facility upgrades and improvements. There haven’t been any substantial changes in how customers approach this today.

Just a couple for me. Mike, on the mix for '19, knowing what you know now with your backlog and understanding there's still short-cycle stuff in the business you can't initially predict, but would you say the mix is neutral, better, or worse than what you've seen in '18 mix of sales?

Well, we're pulling a piece together now. We haven't taken a look at mix yet, but what I'd say is it comes back to running the whole P&L, understanding that we want to get leverage EPS growth in the business, cash flow ROIC to be where it's been historically and we'll work at each of our businesses to figure out what that looks like, but we don't have an early read on mix. I mean, at this point, if you're modeling anything, I'd model neutral mix. We wouldn't have any better advice for you at this point.

Okay. And then for institutional, I believe you're expecting 2019 to be a better year than 2018, correct? So does that turn out to have a positive or neutral effect on Service?

Long run, it's positive because it's where the Service business gets billed is on the engineered systems. And then in the short run, you get a little bit of a gross margin hit, but overcome eightfold over the long run with the Service business that tails on top of that. So as you're modeling 2019, it's negligible but it would lean toward a little bit more compressed margin. But as you lean toward the out-years, the Service starts even in the warranty period. It tends to be a very good story.

Okay. And then last one on Industrial, on compressors. Can you level set us on Service? You noted that is growing, outpacing equipment this quarter on orders, but where are you in terms of percentage of revenues on compressor service?

About 50. I mean, it's sort of about half the business.

I'd like to thank everyone for joining us on today's call. As always, Shane and I will be available to take calls and questions today and certainly over the next several days and the coming weeks. We'll be on the road in New York and in the mid-Atlantic, so we hope to see some of you very soon. Thanks.