Lennox International Inc Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Second Quarter Conference Call. As a reminder, this call is being recorded. I’d now like to turn the conference over to Steve Harrison, Vice President of Investor Relations. Please go ahead.

Good morning. Thank you for joining us for this review of Lennox International's financial performance for the second quarter of 2020. I'm here today with Chairman and CEO, Todd Bluedorn; and CFO, Joe Reitmeier. Todd will review key points for the quarter and the outlook, and Joe will take you through the company's financial performance and guidance. To give everyone time to ask questions during the Q&A, please limit yourself to a couple of questions or follow-ups and re-queue for any additional questions. In the earnings release we issued this morning, we have included the necessary reconciliation of the non-GAAP financial measures that will be discussed to GAAP measures. All comparisons mentioned today are against the prior year period. You can find a direct link to the webcast to today’s conference call on our website at www.lennoxinternational.com. The webcast will be archived on the site and available for replay. I would like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Lennox International's publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. Now let me turn the call over to Chairman and CEO, Todd Bluedorn.

Thanks, Steve. Good morning, everyone, and thank you for joining us. Let me start with a quick overview on the second quarter that was significantly impacted by the COVID-19 pandemic and then discuss the updated outlook for 2020, in which we’re raising guidance for revenue and earnings for the year. For the second quarter, company revenue was $941 million, down 14%. GAAP operating income was $136 million, down 36%, and GAAP EPS from continuing operations was $2.62, down 7%. The second quarter last year included an insurance benefit of $26 million and a pension settlement charge of $61 million. Total segment profit was $153 million, down 24% from the prior year quarter that included an $18 million insurance benefit. From an operational perspective excluding the insurance benefit, total segment profit was down 17%. Total segment margin for the second quarter was 16.3%, down 210 basis points as reported and down 50 basis points from an operational perspective. Adjusted EPS from continuing operations was $2.97, down 21% as reported and down 12% from an operational perspective. Our Residential segment in the second quarter revenue was down 6%; revenue from replacement business is now high single digits; revenue from new construction was down low single digits. Residential segment profit was $127 million, down 17% as reported and down 6% on an operational basis excluding the $18 million insurance benefit in the second quarter a year ago. Segment margin was 19.7% in the second quarter, down 260 basis points as reported and up 10 basis points on an operational basis. Our Residential business improved each month through the quarter and was up 7% in June as the economy continued to reopen and the weather heated up for the summer. Cooling degree days for the second quarter overall were up 4% from the prior year quarter. For the month of June, cooling degree days were up 12% from last year. The hot weather has continued month to date in July and we're seeing strong Residential growth on excellent operational execution by the team to capitalize on market opportunities. Turning to our commercial-facing businesses, they're more heavily impacted by the pandemic as we expected. On the Commercial business segment, revenue was down 28%, segment profit was down 34%, and segment margin contracted 170 basis points to 18.9%. National account revenue was down approximately 40% and regional and local revenue was down approximately 20%. Breaking down the revenue another way; replacement was down 35%, and new construction was down nearly 20%. On the service side, Lennox National Account Service revenue was down about 20%, VRF revenue was up low single digits. While overall commercial equipment was down 30% in the second quarter, we're seeing signs of relative improvement in the business with the commercial equipment backlog currently down 20% year-over-year. Commercial continues to win new business and position for future growth. Commercial won 15 new national account customers in the first half, including 6 in the second quarter. Turning to our Refrigeration business segment. Revenue was down broadly across our businesses in North America and Europe, declining 26% at constant currency. Segment profit was down 53%, and segment margin contracted 460 basis points to 8.2%. North America revenue was down more than 20% and Europe revenue was down about 30%. As in our Commercial business, we are seeing signs of relative improvement in refrigeration as well. Backlog is down approximately 20% year-over-year. Overall for the company for the second half of the year, we continue to face highly uncertain market conditions. Our stock repurchase program remains on hold currently given the high uncertainty. But we continue to be encouraged by the performance of the Residential business and relative improvement in the Commercial and Refrigeration businesses. We continue to maintain a strong balance sheet and expect a strong year of cash flow generation. We continue to target $340 million of free cash flow for 2020. The company has executed well on its $115 million of in-year SG&A savings for 2020, and we manage decremental EBIT margin of 20% on an operational basis in the second quarter. We are raising our financial guidance for 2020 and now expect adjusted revenue to be down 10% to 15% and adjusted EPS from continuing operations within a range of $7.90 to $8.70. As I turn it over to Joe, I will just mention that Lennox has a seasoned team with experience managing through economic downturns while continuing to invest and advance the company's position. All of us are focused on capitalizing on market opportunities and share gains. Now over to Joe.

Thank you, Todd, and good morning, everyone. I'll provide some additional comments and financial details on the business segments for the quarter, starting with Residential Heating & Cooling. In the second quarter, revenue from Residential Heating & Cooling was $645 million, down 6%. Volume was down 8% and price and mix combined was up 2%, and foreign exchange was neutral to revenue. Residential profit was $127 million, down 17% as reported. Segment margin was 19.7%, down 260 basis points as reported. Segment profit was negatively impacted by the year-over-year difference in the insurance benefit, higher warranty expense, and the COVID-19 pandemic that led to lower volume to factory inefficiencies. Partial offsets included favorable price and mix, lower material, freight and distribution costs, and lower SG&A expense. Turning to our Commercial Heating & Cooling business. Commercial revenue was $188 million, down 28%. Volume was down 27%, price and mix combined was down 1%, with price up and mix down. Foreign exchange was neutral to revenue. Commercial segment profit was $36 million, down 34%. Segment margin contracted 170 basis points to 18.9%. Segment profit was negatively impacted by unfavorable mix, higher warranty expense, and the COVID-19 pandemic that led to lower volume. Partial offsets included lower material, freight and distribution costs, and lower SG&A expense. In Refrigeration, second quarter revenue was $108 million, down 27%. Volume was down 27%, price and mix combined was up 1%, and foreign exchange had a negative 1% impact on revenue. Refrigeration segment profit was $9 million, down 53%. Segment margin was 8.2%, down 460 basis points. Segment profit was impacted by higher warranty expense and the COVID-19 pandemic that led to lower volume and factory inefficiencies. Partial offsets included lower material, freight and distribution costs, lower SG&A expense, and favorable foreign exchange. Regarding special items in the second quarter, the company had net after-tax charges totaling $13.4 million. This included $7.9 million for restructuring activities, $2.6 million for personal protective equipment and facility deep cleaning expense incurred due to the pandemic, and net $2.9 million in charges for various other items. Corporate expenses were $19 million in the second quarter, down 22% from the prior year quarter. Overall, SG&A was $130 million, down 15% from the prior year quarter. In the second quarter, the company generated $105 million of cash from operations compared to $30 million in the prior year quarter. Capital expenditures were $19 million compared to $16 million in the prior year quarter that also had approximately $6 million of proceeds from insurance. Free cash flow was approximately $87 million in the quarter, up from $20 million in the prior year quarter. The company paid approximately $30 million in dividends in the quarter. Total debt was $1.39 billion at the end of the second quarter, and we ended the quarter with a debt-to-EBITDA ratio of 2.4. Cash, cash equivalents, and short-term investments were $49 million at the end of June. Now, before I turn it over to Q&A, I will review our current market assumptions and guidance points for 2020. For the industry overall, we expect North American residential HVAC shipments to be down mid-teens. We expect both commercial unitary shipments and refrigeration shipments to be down 25% for the industry. Looking at the company's performance in the first half of the year and the outlook for the second half, we are raising 2020 revenue guidance from a range of down 11% to 17% to a new range of down 10% to 15%. We are raising 2020 guidance for GAAP EPS from continuing operations from a range of $7.07 to $8.07 to a new range of $7.31 to $8.11 for the year. We are raising 2020 guidance for adjusted EPS from continuing operations from a range of $7.50 to $8.50 to a new range of $7.90 to $8.70 for the year. The various puts and takes in our financial guidance for 2020 remain unchanged. We continue to expect a benefit of approximately $25 million in net price for the year. We still expect a $20 million benefit from sourcing and engineering lead cost reductions. Residential factory productivity is still expected to be a $10 million headwind. Residential mix is still expected to be flat, and we still expect tariffs to be neutral. Commodities are expected to be a $20 million benefit this year, and we continue to expect freight to be a $10 million benefit. Now, a few other points to mention in our financial outlook. Corporate expenses are still targeted to be $75 million. And as we talked about last quarter, we have taken $115 million of SG&A cost reduction actions in total to benefit the second, third, and fourth quarters of this year. Net interest expense and other expense guidance remains approximately $40 million. And we still expect an effective tax rate in the range of 21% to 22% on an adjusted basis for the full year. We continue to expect the weighted average diluted share count for the full-year to be between 38 million to 39 million shares. We repurchased $100 million of stock in the first quarter and the $400 million plan going into this year. Our stock repurchase plans currently remain on hold. We continue to target capital expenditures of $120 million this year. And our guidance for free cash flow remains approximately $340 million for the year. And with that, let's go to Q&A.

And first from the line of Julian Mitchell with Barclays. Please go ahead.

Hi, good morning.

Hey, Julian.

Hi. Maybe just the first question on the revenue outlook. So it looks like your guidance on revenue implies the second half is down mid-teens year-on-year, so similar to the Q2 decline. But you seem to have better momentum in Residential. And you even talked about stabilization in the other two divisions. So maybe just help us understand that second half revenue outlook.

I'll be very clear. So I won't dance around the question. If the market environment remains like it is today, we're going to do better than the midpoint of our guide. The concern that we have is that there's a lot of moving pieces, both medically with the pandemic and the impact that it has on end markets. And so we baked that into our guide, but if you've been asked a question, I'll answer a question in July; our Residential business was up mid-teen. So we have strength in July. And if things stay the way they are, we're going to do better than the guide, but the concern is a changing world and a changing marketplace, and that’s reflected in the guide.

Thanks. And then just secondly on the profit margins. Maybe clarify if you can, how much of that $115 million of SG&A cost out is still left to be booked in the P&L in the second half? And also clarify the decremental margin, I realize there's different categories of it, but I think if you take the adjusted number of 20% in Q2, are we right in thinking that the second half you're assuming that's around the mid-teens number at the midpoint of guidance?

I will address the last part first. Yes, you are correct to assume that for the second half of the year, the adjusted number of decrementals is in the mid to high teens based on the current guidance. Regarding the $115 million, we implemented all cost reductions and salary cuts effective May 1. Therefore, I would consider May and June as the full run rate savings for the $115 million, and in the third and fourth quarters, all three months will reflect the run rate of those savings.

That's helpful. Thank you.

Our next question is from the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Hey, good morning, gentlemen.

Hey, Jeff. I want to start with your headline in your note of 'weather beats COVID' was the best headline I’ve seen in a while. I enjoyed it.

I want to give credit to my associate for that. In our checks, we learned a lot about the supply chain. I know that some facilities, not yours, were closed in Mexico, and it seems that your inventories on the balance sheet are low. Can you talk about how Residential appears to be improving and your ability to manage inventory, demand, and deliver the right products to your dealers?

Yes, we did a really good job in the second quarter. And there's a continual triage going on, I think across corporate America, certainly within our industry and certainly within our company, almost a whack-a-mole is another analogy, but our team and suppliers have done a great job through this. Our supply chain is flowing and our manufacturing plants are all up and running and we're focusing on meeting the demand in the market. I think we're as good or better positioned than anyone in the industry as we flow through the balance of the year.

Okay. Regarding Commercial, you mentioned some signs of stabilization. Is this improvement due to the reduction in work stoppages, or are there other better trends you’re observing?

Let me provide some details on your questions, Jeff. When we consider the commercial unitary business in North America, we break it down into three segments. About 40% of the market consists of planned replacement, mainly for national accounts. We anticipated a rapid decline in this area, and indeed, orders fell by 40% to 50% in April and May. However, they have improved and are stronger in June, so clients may currently be operating at half that level. Another 20% of the market is new construction; this segment didn’t decline as quickly as planned replacement because it is discretionary and decisions can be made quickly. New construction projects are ongoing, so this segment is just starting to see a decline. The remaining 40% involves emergency replacement or flow business, similar to the residential sector. This segment has slowed down as well, but not to the extent of national accounts, which have seen a decline of about 15% to 20%. In summary, we have witnessed improvements primarily in planned replacement national accounts where we maintain a strong position. As I mentioned earlier, while revenue was down 30% in Q2, our backlog has decreased by around 20%.

Okay. Thanks, guys.

Our next question is from Gautam Khanna with Cowen. Please go ahead.

Yes. Thanks, guys.

Hey, Gautam.

Couple of questions. First, I was wondering any discernible trend on mix in resi? Are you seeing a mix down or because mix held up pretty well in July and …

Yes. I mean, the mix in the Residential business was up slightly in the second quarter. We're still guiding for it to be flat year-over-year. There's lots of moving pieces on mix in any given quarter, but I think one strength is our Lennox branded product performed better than our ally branded product, and at the gross margin level it has higher margins.

Okay. So you're not seeing a mix. And then secondly, just competitively, have you seen any change in behavior from your principal competitors in the U.S on the resi side?

No change in behaviors. That's a specific question about Trane and Carrier that's often asked. I mean, I don't think it's a secret and certainly not a secret in the industry that Goodman's had some production issues, and that's opened up some opportunities for us and others in the industry to sort of pick up some of the business that Goodman hasn't been able to meet.

And lastly, just pricing. I mean, obviously you're getting a little bit of price mix hasn't been worse. So any potential to actually raise prices in this environment, or is it not supportive of that type of dynamic?

The pricing is more as you go into the season; you put a price in place and we have a price in place. And again, we have longstanding relationships with these customers, with these dealers. And sort of in a hot summer to raise prices, you really don't want to do that. So I think we are going to get the price that we committed to, and the markets help and support that with the demand.

Thank you. Nice results.

Thanks.

Our next question is from the line of Deepa Raghavan with Wells Fargo Securities. Please go ahead.

Hey, good morning.

Good morning.

New construction is quite strong, especially in the residential sector. I'm interested in your thoughts on new construction trends for the remainder of the year. Is this area likely to be more profitable than replacement?

Our best guess is that it won't stay better than replacement. I think new construction, although it's been very resilient and low interest rates are helping. Our best guess is that in the second half of the year that tails off and add-on or replacement, which has been increasing sequentially stronger in April, May, and June continues to hang in there. And so we expect new construction to tail off. Another thing that I just want to weave into the conversation around some of our confidence about add-on or replacement is, if you remember, Deepa and others on the call, during the great financial crisis, the canary in the coal mine in our industry was parts sales started to grow very quickly and that was an indicator that people were repairing rather than replacing. We haven't seen that yet. So what we saw in the second quarter was that for our Lennox business, our residential replacement was down low single digits, while parts were down high single digits. And for just for the month of June in our Lennox business, our residential replacement was up mid-teens and parts and supplies were up 1%. So we're not seeing anything like we saw during the financial crisis. And to me that's an indication that our replacements are hanging in there, and I would expect new construction to slow down.

Got it. Thanks for the color. My follow-up is on cost actions. The last time we spoke about cost actions, because some of them are temporary, mostly on the salary front. Just given how Residential trends have outpaced expectations in Q2 and how July is trending strong. I understand the uncertainty ahead, but how are you thinking about the timeline of rolling back some of those temporary measures, and does your guide range assume any rollback, at least at the better end of it?

Our guide range assumes our perspective on how the balance of the year is going to play out. And I understand that sounds like a political answer. So, yes, it encompasses our best guess of things coming back. In terms of the $115 million coming back, about 40% of the $115 million were what we call pay temporary salary reductions, STI or short-term incentive, that sort of thing. And as we do better in 2020, especially in the second half of the year, I can imagine some of that would come back, but that's all encompassed by our guide. So there won't be bad news that we give you later because we decided to pull some of it back.

Got it. Thanks so much.

And next we go to line of Joe Ritchie with Goldman Sachs. Please go ahead.

Thanks. Good morning, guys.

Good morning, Joe.

Hey, Todd, my first question is regarding the length of the residential replacement cycle and how far we are into it. Do you think that the changes in the working-from-home dynamic and the potential strain on HVAC systems could alter the trajectory of that cycle? We would appreciate any insights you can share on this.

I think it could. The honest answer is that I don't know. When you consider people working from home, it becomes their refuge, their life, and they may have the desire to invest in and protect it. This is assuming that unemployment doesn't rise back to 20% and that people have disposable income. The repair versus replace dynamic I mentioned earlier supports this view, indicating that things have evolved. However, as we've noted for some time, this is not an exact science. While some sell-side models have tried to predict how this will unfold, there can be some misleading accuracy. I doubt anyone would have anticipated that with degree cooling days up 4%, we would observe this level of performance amidst COVID, including ourselves. Therefore, I believe the market is quite resilient.

It's good to hear. Regarding the second question about the Commercial business, I appreciate the breakdown you provided. When considering the opportunity for a potential service tail that may return more quickly, I understand we're currently facing challenges with the ongoing surge in the U.S. How are you viewing the service tail for that business specifically, and what is your ability to gain onsite access for repairs and servicing your commercial equipment?

We currently have access to our North American service business, which has been operational throughout. We are classified as an essential business, and the products sold through our distributors and dealers are essential as well. Although service revenue has declined, we expect it to stabilize or possibly increase in the second half of the year. As for planned replacements, there has been a significant drop, but we anticipate a rapid recovery. While we need to see more favorable conditions, the order rate has improved from a decrease of 40% to 50% in April and May to a drop of around 20% now. Although it's not at a healthy level, it is certainly an improvement from a few months ago.

Great. I'll get back in queue. Thank you.

Our next question is from John Walsh with Credit Suisse. Please go ahead.

Hi, good morning.

Good morning, John.

I have a question about the strength of the exit rates you're experiencing and whether you can quantify how much of that may be attributed to contractors not being able to enter homes during the peak of COVID in April and May. Is some of this a catch-up effect, or do you believe these exit rates are sustainable moving forward?

No, I don't think so. When we speak with our contractors, they've had access the entire time. I believe it relates to the hot June. As a result, degree cooling days increased by 4% for the quarter, and I'm checking my notes to ensure I have the correct number.

12%.

We are up 12% … in June. So that warm weather helped us in June. I think the other thing that we're going to have to see is, we think we can share in the second quarter. In fact, I know we gained share in the second quarter because I see the industry data, and we had mentioned exiting 2019 that we had regained business with 80% of our contractors that have been impacted by the tornado, and we're now seeing that flow through in our volumes. We also, as I mentioned in the first quarter call and the last fourth quarter call, that we are focused on new business and we had a significant backlog of additional new business coming into the year. And we're seeing the benefits from that. And as I mentioned earlier, some of the issues that our competitor or competitors producing products. So I think it's a combination of a repair versus replace, replace versus repair, staying in place, some hot weather. But I actually think share gain is one of the largest reasons we have such a strong June and, quite frankly, we’ve had a very strong July.

Great. Thanks for that. And then, just curious if you're seeing your customers on the resi or the commercial side do more add-ons around indoor air quality. I don't know if that rolls into the mix piece, but just trying to see if there might be more add-ons that you might be able to benefit from as you capture that?

Indoor air quality scenario, we focused on for years, both in residential and commercial. And when you think about indoor air quality, it's about air purification, which is filters, HEPA filters and UV lights without ventilation and circulation. And then third is about humidity control. And it's always about balancing bringing in outside air and that's part of the ventilation in that humidity control, and also the capacity, as you bring out the outside air that's untreated. We’re definitely seeing increased interest in IAQ, indoor air quality in both Residential and Commercial. Our Residential pure air equipment is the best in the street. And that's just not our saying that, that's consumer reports and Commercial similar to Residential. We work with our customers to address their solutions. So I think it's important. And I think it's about you have to have the capability to win the customer and serve the customer, but it's not a big enough dollar item, even if people add it to the mix of the equipment to sort of have an outsized impact on sales and margin. I think it's about a binary item that you have to have this capability to be able to talk to your customers and customers and your dealer contractor customers to win business, and we're well positioned to do that.

Great. Thank you.

Next we go to the line of Nicole DeBlase with Deutsche Bank. Please go ahead.

Yes, thanks. Good morning, guys.

Good morning, Nicole.

Just maybe starting with the free cash flow guidance, just curious why that's not also moving higher as EPS was higher and maybe same topic, any thoughts around working capital potentially flipping to an inflow in the second half of the year?

I think we'll still continue to generate cash from working capital in the second half of the year. Given the caution that I identified around the EPS, even a greater caution around cash flow, just historically our ability to forecast it. So, I mean $340 million is our best guess right now, but similar to what I've said on earnings, if the world stays the way it is, we'll do better than $340 million.

Thanks, Todd. For my second question, I’d like to ask about the potential for dealers to restock their inventory. This hasn’t really occurred due to COVID like it typically does in seasonality. Are you beginning to see dealers start to restock? If not, could this open up the possibility for increased performance in the third quarter if restocking does begin?

We've observed that dealers began restocking in the second quarter. If the hot weather continues and July and August are strong, we can expect additional loading at the distributor level, which constitutes about 20% of our allied business. The timing of distributor reloading is crucial, as they deferred significant purchases in April and May. We started to notice them making substantial purchases in June. This indicates that there is more momentum and a replenishing of the channel for us, particularly in our allied efforts on the Lennox side, where dealers also began buying in May and June.

Got it. Thanks. I'll pass it on.

And next we go to Jeff Sprague with Vertical Research. Please go ahead.

Thank you. Good morning, everyone.

Good morning, Jeff.

Todd, on the surface, the comps start looking tougher in the back half. I'm just wondering if you could give us a little color as we try to think about Q3 and this really strong result here in July. How the comps for the remainder of the quarter kind of play out, and was July particularly easy this year?

No, I'm recalling a bit from memory, I'll be honest, Jeff. I didn't prepare for that specific question. Last July was not necessarily easy. If I remember correctly, we had a cool start to the summer last year. I think May and June might have been easier, but we did experience a certain level of cooling days, and July was pretty typical for us. As I recall regarding the fourth quarter, we discussed warm weather and how it affected our furnace stations. I don't believe the comparisons are significantly harder. When you look at the reported numbers, the tornado impact was much more noticeable in the first half of the year compared to the second half. However, when you adjust for the tornado impact, the comparisons weren't that different.

Can you provide some insight into the factory inefficiencies? Is it just the $10 million that Joe mentioned, or are there other, possibly more difficult to quantify inefficiencies occurring in the factories?

The inefficiencies were largely due to traditional absorption issues, meaning we don't have enough volume to cover fixed costs. Additionally, absenteeism has increased somewhat, particularly in our factories located in areas like Georgia, Iowa, and South Carolina, which have been affected by COVID. Initially, we anticipated achieving $10 million in factory productivity this year, but now we’re looking at $10 million in inefficiencies, indicating a $20 million swing caused by both volume and absenteeism.

And then finally what do you need to see to restart the share repurchase? Everything you said here today sounds pretty constructive. Obviously the future is cloudy, but anything in particular you need to see just another quarter under your belt, how are you thinking about that?

I think the world is still changing quickly, so we definitely need another quarter to assess our situation. We will see how the third quarter performs. I may have mentioned this publicly before, but we need to make sure that we continue to request shared sacrifice from our employees regarding pay cuts and the absence of bonuses. We must start making some adjustments before we aggressively invest in share buybacks. It's important to find a balance in how the benefits are distributed.

Great. Thank you.

Our next question is from Nigel Coe with Wolfe Research. Please go ahead.

Thanks. Good morning. We've covered a lot already, Todd. If we take a step back to 2Q and look at the monthly cadence, I'm not asking for a detailed breakdown. Regarding the plus 7 in June, should we make any adjustments for sales days? Many companies seemed to have extra selling days in June. Is there any distortion, or in your opinion, is that plus 7 a solid exit rate for 3Q?

I think the plus 7 is good. That's it.

Okay, great. And then on the inventory side, obviously your inventory is …

I would say the growth in mid-teens in July is accurate day for day.

Right. Exactly. Yes. Inventory is down 10% from the fourth quarter, which is quite unusual given the current situation. What needs to happen, considering it seems Residential is maintaining this mid-teens pace through the third quarter? Do you need to increase production levels to restock? Any insights on how that inventory looks across different business segments would be helpful. I'm curious if your free cash flow guidance includes some level of inventory rebuilding. Also, any updates on income taxes for the third quarter? We're seeing some deferrals of income tax payments as well.

On the inventory build, we started ramping up production as soon as we began to see how the markets were behaving. We have already increased production to stay ahead of demand. As I mentioned earlier, during the summer when it's hot, we need to navigate both the supply chain and inventory levels, particularly considering COVID. Our teams are working diligently, and we believe we are well positioned to meet demand, as effectively as anyone in the industry. I’m not certain I understood the question regarding taxes.

Yes. With the CARES Act, I think there was a bump down in cash tax payments into July from …

Yes, it's a bit of a cash bump for us on the timing of the cash. But honestly it's the minimis for us.

Yes, it's a modest benefit for quarter or two, but once again it's a timing issue.

Okay, great. Thanks guys.

And our next question is from Josh Pokrzywinski with Morgan Stanley. Please go ahead.

Hi, this is Breindy on for Josh.

Hey.

I wanted to ask about the progress of reacquiring tornado customers in the current environment. Additionally, how are the incentives and rebates trending compared to the $10 million range that was mentioned in December?

It is progressing as we anticipated and communicated. I am confident that we gained market share in the second quarter, supported by the numbers I've seen. A significant part of this is that we have regained about 80% of the impact from the tornado with our customers, which we expected to reflect in 2020, and we are witnessing that. Regarding the incentives and benefits provided to dealers, we are adhering to our commitments and will continue with those incentives even in a strong market. We are dedicated to maintaining this course.

Okay. That's great. I will leave it there. Thanks.

And our next question is from Steve Tusa with J.P. Morgan. Please go ahead.

Good morning, guys.

Hey, Steve.

Todd, that shot at the sell side really hurts. It's just little sensitive these days. So I thought I was on the Watsco call there for a second. But …

I thought I complimented Jeff Hammond.

Yes, you certainly did. However, while discussing our models, there is indeed some false precision, which is accurate. I believe there might also be some false precision in your models since things are turning out better than you anticipated in our April conversation. You mentioned that if consumer confidence declines, you would be worried about its impact on consumers, which is understandably a challenging and unprecedented situation for everyone to predict. What do you think is driving this situation? It's clearly different from '08 and '09, when we faced negative savings rates and a collapsing housing market. Is it due to people saving significantly more? Or are they using their resources more intensively because they're spending more time at home? With some savings from stimulus checks or other sources, what feedback are you receiving regarding why unemployment and consumer confidence haven't reflected more significant declines in these numbers?

I think there are several factors at play, and I'll be modest in saying that we are still figuring this out. It’s positive news, and although we are not entirely certain what is causing it, we are certainly pleased it is happening. To summarize, we are not seeing a shift from repair to replace; replacement is still holding strong. I believe a combination of factors is contributing to this. On one hand, people are spending more time at home and are increasingly motivated to invest in their living spaces. Previously, when they didn’t spend much time at home, they could defer these investments. Now that they are home more often, they want to make improvements. I don't think it’s because people are overusing their units. Studies indicate that a significant percentage of people don’t have programmable thermostats, and even those who do rarely adjust them. Units generally operate in a steady state, with only minor fluctuations. Additionally, not everyone agrees with this perspective. I maintain that people are reluctant to invest in depreciating assets, especially during the peak of the financial crisis when home values plummeted. The idea of installing new units during that time felt daunting. However, the situation seems different now; home values are increasing, new construction is robust, and demand for homes is high. People appear more willing to invest. Furthermore, there might be a psychological shift due to COVID-19, as people sense a resolution to this crisis—unlike the financial crisis, which felt more uncertain in terms of its causes and resolution timeline. Here, we can recognize the situation and anticipate a conclusion, even if there is debate about when that will occur.

Outside of the situation in April and May, if we look ahead to next year in a more normalized environment, potentially with higher unemployment, what should we expect for next year? It seems this might not be the reset of the cycle we anticipated, but rather a return to more normalized fundamentals as people continue with their lives.

I don't know Steve. I mean, again, that's sort of the humble nature of my answer. I think we are going to have to see how this plays out. For example, I mean, if everything goes back to traveling and work 100% and everything is exactly as it was back at the end of '19, then some of the factors that I talked about are no longer at play. I can imagine a world that might be different.

Right. Right.

You work some more, and so I'm not exactly sure how do we set for 2021.

Okay.

I think we are happy. And I wasn't taking a shot at your model, I was just making the point that we and you and others maybe had thought the cycle had ended and it is the case maybe not.

No, I'm not taking it personally. I represent all the sell-side analysts who may have been overly precise in our models. Just to clarify, can you provide an update on the $115 million? Specifically, could you differentiate between what is temporary and what is structural as we look ahead to next year?

About 20% of $115 million is attributed to salaries and headcount reductions, while around 40% comes from discretionary spending such as travel, marketing, and incentive trips. The remaining 40% is tied to pay actions, which include salary reductions of 6% for salaried employees, 12% for executives, and 50% for myself. My perspective is that if pay actions recover, the other 60% will be influenced by market conditions and our strategic response.

Right. A little more kind of variable with what's going on with the volumes.

Correct.

Okay. All right. Thanks a lot. Thanks for the color, as always.

Our next question is from Chris Dankert with Longbow Research. Please go ahead.

Hey, good morning, guys. Thanks for taking my question. I guess first off, any color or additional details as far as kind of how labor markets are impacting growth, whether it's in terms of the actual construction market or just are we seeing good access to customer sites, what are you hearing from contractors on the ground in terms of both labor and then being able to access customer sites today?

Almost no barrier that I'm aware of, customer sites both Commercial and Residential. We're an essential industry and they need us, and we're going in personalized. I just had my air conditioner repaired. I had an issue with it and technician arrived and matched up, it's booted up, it's plugged up. And my wife and kids in the bedrooms and the guys did magnificent work and left and I think we're seeing that across the industry in the offsite. In terms of labor availability, I think it's strong. I think it's better than it was a year ago. I think the only issue that we are seeing is when you're running a factory or a service business, if you have COVID strike, then you have to deal with it and continue appropriately in quarantine, so that causes absenteeism and so we and our channel partners work through those issues, but I think we're all focused on safety and taking all the right measures and are working through all the issues.

Got it. Got it. That's helpful. Thanks. And then, my apologies, I fully appreciate the difficulty of trying to be precise to moment as we've kind of gone through, but I just have to ask again, thinking about the cadence of just volumes in a typical year, for things to kind of fall apart as maybe the guidance assumes, things would have to really tick down in August. Otherwise, we're kind of through the bulk of the selling season now. Is there any visibility as to why things might slow in August or is it just conservatism and just taking a cautious view?

August marks the conclusion of the AC selling season, but the fourth quarter is significant for us, contributing about 20% to 25% of our volume, which is primarily driven by furnace sales. The fourth quarter is still important. It's somewhat linked to COVID, which has been surprising and humbling to witness how quickly the situation changed, both downwards and then upwards. Steve correctly pointed out that my initial expectations didn’t align with reality; I had expected a mid-teens increase in July for the Residential segment, but we are pleased with the results we've seen. However, we recognize the need to remain cautious since things could turn around again. Therefore, we'll approach this one quarter at a time.

I completely understand that. While it's manageable to deal with some discomfort, when the temperature drops to 32 degrees, you will need to replace the furnace. It's really about having the flexibility to address those situations. Thank you for the insight; I appreciate it.

Although in my house, my dad would make us freeze. Okay, but enough about me. Let me wrap up; market conditions remain highly uncertain as we just sort of talked about here, but we are executing well, very well on market opportunities and share gains. The third quarter is off to a strong start for Residential and our Commercial and Refrigeration businesses just continue to see relative improvement. We’ve raised our guidance for 2020 and look forward to the remainder of the summer and the second half of the year. Thanks everyone for joining us. Have a good day.

Ladies and gentlemen, that does conclude your conference. Thank you for your participation. You may now disconnect.