Good morning, and welcome to Carrier's Third Quarter 2023 Earnings Conference Call. I would like to introduce your host for today's conference, Sam Pearlstein, Vice President, Investor Relations. Please go ahead, sir.

Thank you, and good morning, and welcome to Carrier's Third Quarter 2023 Earnings Conference Call. With me here today are David Gitlin, Chairman and Chief Executive Officer; and Patrick Goris, Chief Financial Officer. We will be discussing certain non-GAAP measures on this call, which management believes are relevant in assessing the financial performance of the business. These non-GAAP measures are reconciled to GAAP figures in our earnings presentation, which is available to download from Carrier's website at ir.carrier.com. The company reminds listeners that the sales, earnings and cash flow expectations and any other forward-looking statements provided during the call are subject to risks and uncertainties. Carrier's SEC filings including Forms 10-K, 10-Q and 8-K, provide details on important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements. Once the call is open for questions, we ask that you limit yourself to one question and one follow-up to give everyone the opportunity to participate. With that, I'd like to turn the call over to our Chairman and CEO, Dave Gitlin.

Thank you, Sam, and good morning, everyone. I am very proud of our team for delivering another strong quarter, enabling us to again increase our full year guidance. HVAC environment security sales were both up mid-single digits with the overall company delivering yet another quarter of double-digit aftermarket growth. Adjusted operating profit and adjusted EPS were both up over 20% year-over-year with adjusted operating margins up 240 basis points in the quarter. The HVAC and Fire & Security segments both delivered record adjusted operating margins in the quarter, approximately 21% and 18%, respectively. Free cash flow performance also continues to be strong, positioning us for some upside for our full year guidance. Bottom line is we continue to perform while we transform, as you can see on Slide 3. We are a team that is very clear eyed about macro challenges. We are focused on controlling the controllables, driving operational excellence, being tenacious about customer centricity, out innovating our peers and consistently delivering on our commitments. With 2 months left in the year, we are confident that in 2023, we will deliver mid-single-digit organic growth, 15% adjusted EPS growth, margin expansion despite the negative impact from consolidating Toshiba Carrier and strong free cash flow. Not only are we poised to close out 2023 on a strong note, we have significantly matured our productivity processes. So we will enter 2024 with even more rigor and detailed plans around our cost reduction activities positioning us for further margin expansion next year and beyond. We also have confidence in continued growth driven in part by our aftermarket and recurring revenue traction as you see on Slide 4. We're on track for 80,000 chillers under long-term agreements and 30,000 connected chillers by year-end. The attachment rate in Q3 was approximately 50%, nearly double pre-spin…

Thank you, Dave, and good morning, everyone. Please turn to Slide 8. Sales in the quarter were $5.7 billion with organic growth of 3%, a 1% tailwind from foreign currency translation and a 1% net contribution from acquisitions and divestitures. The latter was substantially all driven by one month of Toshiba Carrier before becoming organic at the beginning of August. Q3 adjusted operating profit of over $1 billion was up more than 20% compared to the prior year on 5% reported sales growth. Strong productivity and price cost helped us expand our adjusted operating margin by 240 basis points to 18.2%. That is despite a 30 basis point headwind related to the Toshiba Carrier consolidation. Reported earnings conversion was 65% in the quarter. Core earnings conversion that is excluding acquisitions, divestitures and currency was far higher than that. Adjusted EPS of $0.89 is up 27% year-over-year and includes a tailwind from discrete tax items in the quarter. Free cash flow of about $950 million was up 35% compared to last year. Year-to-date, we have generated over $1.3 billion in free cash flow compared to about $400 million during the same period last year, reflecting improved working capital performance and higher earnings. Overall, a good quarter and better than we expected mainly as a result of better operating performance and the discrete tax items I mentioned earlier. Please turn to Slide 9. Q3 was another good quarter for HVAC. Organic sales were up 4%, driven by high single-digit growth in commercial HVAC, 30% growth in light commercial and double-digit growth in aftermarket. North America residential HVAC sales were down low single digits in the quarter. Overall resi volume was down low double digits and revenues continued to benefit from price realization and positive mix from the 2023 year transition. Destocking is…

Well, thank you, Patrick. In closing, Carrier continues performing while transforming. We had another strong quarter. And more importantly, we again increased our outlook for 2023 with mid-single-digit organic growth, margin expansion, double-digit adjusted EPS growth and strong free cash flow performance, all broadly in line with the value creation framework that we shared with you at our latest Investor Day. So with just a couple of months more to go in 2023, we are, of course, already looking ahead to 2024 with continued confidence in strong top and bottom line growth and cash conversion. With that, we'll open this up for questions.

[Operator Instructions] Our first question comes from Deane Dray with RBC Capital Markets.

We're hearing some commentary about higher inventory in the channel of heat pumps in Europe just all coming from some of the uncertainty about when some of these government stimulus programs will be passed. What's your sense of channel inventory? And how does that play out?

Well, Deane, let me just first give you a little bit of color on just how Viessmann Climate Solutions business has been doing year-to-date. Look, their sales are up about 18% year-to-date. Heat pump sales were up over 35%. They've had strong margin expansion. They're still tracking to the financials that we had thought for this year. And when we look ahead, I could tell you that we are very confident in the overall earnings trajectory that we had put in our business case. Clearly, when you see governments adjust some of their regulations and subsidies from 1 year to another, you may see some impact on the adoption rate of heat pumps. I think what you'll see is what we all saw, which is backlogs got to very high levels. We saw it throughout our portfolio. I think every industrial company saw it, is that as we all face some of the supply chain issues, backlogs were elevated way beyond typical levels. I think that we'll see those backlog levels for Viessmann come back in line with what would have been historic levels. And I do think that when we look at countries like Germany and Italy, you will see some short-term movement in some of the order rates as those legislations play themselves out. But look, there's -- number one, there's no question in anyone's mind, you're going to see this continued transition to heat pumps overall in Europe. And it doesn't take minor swings in oil and gas prices to even accelerate that. Second, they could not be better positioned to outgrow the market. We've talked consistently about their channel, their technology, their brand and how differentiated they are. And especially when I mentioned in my prepared remarks about them introducing new products, which exposes them to a completely new part of the market that they weren't in before when these products come out in 1Q, and they have the advantage of having complete home energy management solutions. So -- and in the background, it wouldn't surprise you that we will push very hard to overdrive on top and bottom line synergies. And we've had a chance to spend a lot of time with Thomas, the leader of that business and his team. The more time we spend with them, the more excited we are and the more confident we are in the value proposition from that combination.

That's all really good to hear. And then second question, can you take us through some of the assumptions on what's going on in light commercial, up 30%? What are the drivers and visibility there, please?

Yes. Look, I mean, we -- sales were up 30%, as you mentioned, Deane, in the quarter. And I think when we look at the full year, we thought light commercial was going to be up 20%. I think for the full year, it's going to be up 30% as well. So when we look at it, there are some verticals that just remain extremely strong. K-12 orders were up 25% in the quarter. The pipeline there is even up 50% and we still see strong demand in some of the value-based retailers. There are some verticals that will be under some level of pressure, things like warehousing and some of things like higher-end restaurants and office space perhaps. But the overall underlying demand, especially in some of the key verticals, is strong and the backlog is still elevated. Normally, you'd have kind of 4 to 6 weeks backlog. And our backlog, as we sit here today, extends into the second quarter of next year. So we'll continue to watch inventory levels similar to what I said for Viessmann is that you did have demand that was and backlog beyond historic levels, those should normalize over time. We'll have to see as we get into next year. We're looking at the EPA ruling, which is data manufacturer with a 3-year grace period. So there will be, as we transition to 455, 454 be there as well. But overall, a great year for that team. And I think that we're pretty well positioned as we head into the first quarter of next year.

Our next question comes from Julian Mitchell with Barclays.

Maybe just a first question around the North America residential HVAC market. So it looks like you're assuming perhaps that volumes there are down perhaps low double-digit, high single digit in the fourth quarter. I wanted to check if that's correct and how you're thinking about the slope of that getting back towards 0 next year. And also sort of when we think about next year, there's some discussion around the scope of the price effects tied to the refrigerants change, i.e., how much of your residential business might be affected by that change. Is it just the greenfield equipment? Or it's also the replacement equipment as well? And I'm assuming furnaces and parts are unaffected by that. Any color on that, please?

Sure, Julian. Let me start with kind of the year and then give a little bit of color on what we see for next year in light of this recent EPA ruling. I think for overall this year, we're looking at resi being down mid-single digits with volume being down in the mid-teens. That would imply overall sales in the fourth quarter down about mid-single digits for resi. And I think that this is the quarter of -- I think this is sort of the most -- the end of a lot of the destocking that we've been seeing. So we want to end this year with inventory levels down at least in the mid-teens versus where we ended last year. So our first priority is always being there for our customers, but we also want to be very purposeful in working with our channel partners on making sure that inventory levels going into '24 are at least down 15% versus where we ended 2022. I had the chance to be with about 100 of our key distributors on Tuesday in Dallas. We talked a lot about this and the regulatory changes. And I think we're all lock-stepped together to go in this year in a way that supports our customers and positions us for next year. I think when you look at the recent EPA ruling that's just come over -- come out over the last week, the good news is that the data of install ruling, what that's going to do is accelerate 454-B systems demand, and we'll likely see more 454-B sales in '24 than we previously thought, and that mix is favorable. And I will say that thanks to the great work of our team, we will technically and operationally be ready to cut in the…

That's very helpful. And then just a quick sort of more financial question. The HVAC segment, I think, Patrick, you had mentioned some maybe temporary sort of headwinds and tailwinds moving around in that third quarter profit number. So maybe just a finer point on that. And I wanted to check that the guidance seems to embed a sort of low double-digit HVAC margin for Q4 and kind of sort of mid-20s operating leverage for the year whole inclusive of the Toshiba impact. Just wanted to check that those are sort of roughly the right thought processes.

Yes. The answer to your last 2 questions, Julian, are yes on both counts. In terms of the HVAC margins, Sam pointed out that the transcript -- the life transcript said that I said that it's a $60 million tax benefit within JV income, within HVAC, it's $160 million, and that was offset by some discrete items that went the other way. But in summary, the large expansion of margins within HVAC, 410 bps year-over-year, despite the headwind from Toshiba Carrier consolidation, it's really driven by strong price cost and productivity. And that is the main driver that we see in that segment that also translates to the overall company. So some minor headwind to that. As I mentioned, acquisitions. We always invested with us a little bit there. But the main driver is productivity and price costs.

Our next question comes from Jeffrey Sprague with Vertical Research Partners.

Patrick, thank you for the color on how you're thinking about the guide. I just want to get a little bit more into the deal, Matt, if we could. You're sitting on $3.9 billion in cash. I just wonder how much of that is sort of usable to consummate the deal versus cash that might be geographically stranded or other things? And I'm sure Viessmann is generating cash here. Does that go out the door to them as a closing adjustment? Or is that accessible to you to sort of self-fund the deal to some degree? And thirdly, just what are you looking at as kind of your blended funding cost based on the actions and locks that you took in Q3?

Yes. I'll start, Jeff, with the cash that we have. So we have $3.9 billion at the end of Q3. We expect that to grow further by the end of the year. You can think of about $1 billion of that generally is what we need to run the business would be, call it, not accessible, we wouldn't plan on using that. The remainder of the cash we would intend to use for the acquisition. So that's one. Two, with respect to cash at Viessmann. The type of acquisition we've done is a lockbox mechanism, which is typical for European deals. And in essence, it means that all these earnings and the cash generated within Viessmann as of January 1 of this year 2023 remains within Viessmann. And we get access to that the day we acquired them. And so we do expect at the time of closing to have access to that cash and to use some of that cash again to pay down some of the short-term -- the terminals we expect to use, for example, to fund the acquisition. The last question you had was, I think, was about the blended rate. And we assumed back in April a little bit of a conservative rate overall at about 6% to finance the transaction. And based on everything we know now, some of the locks we've put in place, we think we're very close to that number. It would also mean that our overall cost of debt, weighted cost of debt post the transaction would be right around 4% based on where interest rates are today.

Great. And just back to the earlier point, so there's a $116 million gain in HVAC segment results in the quarter, but that is fully or mostly offset by what exactly?

Jeff, 1-6, $16 million tax gain within HVAC as equity income. That is all offset by some smaller other items. So $16 million.

Our next question comes from Joe Ritchie with Goldman Sachs.

Dave, can we maybe just talk a little bit about just the broader environment, the market is breaking out, given project financing concerns, higher rates environment, high rate environment, just what are your thoughts on all of the mega projects that have kind of moved forward. Ultimately, what needs for your business, whether you've started to see any of that or a substantial amount of that into your orders. Just any thoughts around that would be helpful.

Yes. Look, I think it was interesting. We saw ABI come out at 44% and exactly what you said, Joe, that there was -- that created a fair amount of anxiety, but there wasn't as much exuberance when it was over 50 for 3 of the last 5 months and it went through a stretch where it was over 50, I think, for almost a year straight. So I think, look, we take those metrics with, I think, a sober view, but a very look at the agility that we have as a team to pivot to where the strength is. So we look at certain verticals that remain just extremely strong, and we see that we still have in commercial HVAC extremely elevated backlog levels going into next year. And it's because that some of the orders we've seen in education, not only K-12 with the Ester funding, but also higher end, very strong data centers. We look at some areas of industrial, not only in the United States. But even though real estate remains under a lot of pressure in places like China, commercial real estate in the United States is under pressure, we see things like the Chips Act and we see things like some of the EV type spending we're seeing in China very strong, and we're winning more than our fair share of a lot of that new construction. And that's driven by some of the regulatory environment, decarb trends. So look, we take a very balanced view. I don't think a lot of people were thinking that light commercial would be up 30% this year, which it will be. I think going into next year, we'll go into next year, good backlog in commercial HVAC. We think that we're sort of bottoming them out in some of the resi space in the United States. We see aftermarket growth double digits. We've done a really nice job with the Abound and Lynx and the whole playbook around driving more recurring revenues to smooth some of the cycles, we've come a long way there. And then I think with some of our businesses like container, we went through a rough patch on container, which we fully expected, and we see that starting to recover here in 4Q going into next year. So I think we'll have a very balanced view. But we'll go into next year looking with good backlog in the longer-cycle businesses, and we still see orders trends in some of the key verticals that I think position us for solid growth next year.

Got it. That's super helpful. And then maybe just a follow-up question, a more financial-oriented question on HVAC margins for 4Q. So Patrick, thanks for all the color. I think we've got. We're all set on the $16 million impact this quarter. But just for 4Q specifically. I know that it's always a much lower volume quarter for the business. But the change sequentially from 20% plus, call it, low double digits seems very substantial. Are there any other moving parts that we really need to take into consideration for 4Q versus the 3Q margins you just posted?

The biggest element, and it's what I'm going to share is from an overall company perspective, but it's the same, of course, for HVAC, even the size of that segment. One, significantly lower sales sequentially due to the season that moves, of course, ready as well as some of the higher-margin businesses. In addition, you heard us talk about ensuring that field inventories are rightsized. So there is some downtime in some of our facilities as well to ensure that we start out 2024 with appropriate levels of inventory. And then we continue to make some investments and JV income is seasonally lower as well in the last quarter of the year as we see every year. I would say those are the biggest moving pieces, Joe.

Our next question comes from Noah Kaye with Oppenheimer.

I want to follow up on the commercial commentary. So I look at the multi-quarter commercial orders trends, kind of flattish here. How do you think about 4Q orders trends in commercial just based off of everything you just described?

Well, look, last year, orders were up around low double digits. We'll have to see orders here in 4Q. It's too hard to tell just yet. But when you look at it, our backlog is up 40% on a 2-year stack. So I think that when we look at it by region, Europe has been almost surprisingly resilient. And we think about -- I mentioned that heat pumps up 70% in the quarter for commercial heat pumps. So we see continued strong demand in Europe, especially for heat pumps. North America we actually had much elevated lead time and backlog levels given a couple of operational issues that we had that are now significantly improving. The team's done a really nice job and making progress in some of our North American operational issues. So as that continues to improve and lead times eventually get back to more normal levels, we'll see orders start to increase there. And then China is kind of a mixed bag. China is under a little bit of pressure certainly on the real estate side. But as I mentioned, some of the infrastructure spend continues to be strong. We had a very recent win here for 6 chillers in China included a lot of our automated system. We're pushing very hard on aftermarket connected devices there. So we'll have to see. But I don't see a huge rebound here in China and 4Q. But hopefully, as we get into next year, things start to stabilize a bit there on the -- some key verticals.

Okay. And then, David, I think there's been so much ink written about this. But since you're closely tracking the performance of the Viessmann business and given how well it's done year-to-date versus some of the headlines out there around heat pump demand. Just help us sort of reconcile the strength of the company's performance year-to-date and what they're doing now to position for all these different regulatory changes and what really drives your conviction that they'll continue to see sales growth and strong performance in '24 and beyond.

Look, there's so much to like there. I mean we've always known that as countries change regulation subsidy levels, that will have quarter-to-quarter impacts. We saw it in Italy last year that Italy had subsidy levels at 110% going back a couple of years and then they changed it to 90%, and that caused year-over-year headwinds in anxiety in Italy. That will smooth itself out over time. But if you're trying to predict what's going to happen as regulations change from 1 year to another, that will have some short-term swings. And I think that's what's being highlighted by some of Viesmmann peers. We're seeing in the German legislation that we do think that the regulation has written will go through. There's still a bit of a debate on the exact subsidy levels. Those subsidy levels will be debated, I think, November 6 and 7 in Germany levels. We expect those will all be promulgated and go into effect in January of next year. If you see an increase in subsidy levels, that will have a natural belling effect on orders as consumers wait for those increased subsidy levels to go into effect. So will that have an impact potentially on 1Q for 1 business from here to there? Of course, it will. But when we step back, we say, is the transition to heat pumps in Europe here to stay? We are 100% confident in that. Is Viessmann the best positioned company because they are not a pure play either heat pump or boiler company? Yes, because they have not only mixed factories, they have mixed lines. So as boilers, there's going to be more boilers next year than we had earlier anticipated, which I think there will be. They make great margins on boilers and they're able to swing their operational performance to support that. And then you look at all the other capabilities they bring to the table, when you combine with a world-class company, there are so many very obvious synergies and then a lot of hidden synergies as we apply their technology to our businesses across the world. And we bring in, say, for example, the Carrier brand into their channel, those are immediate revenue synergies that can offset like if there's some 1Q heat pump headwind in Germany, you can look at all these other things, whether it's additional solar PV battery cells, things like that, or revenue synergies. So we just feel so confident in the business, in the team, in the overall trajectory and the overall earnings profile of that business.

Our next question comes from Gautam Khanna with TD Cowen.

I wanted to ask in the resi business, are you guys seeing any evidence of trading down an increase in repair versus replace? We've heard some of the HVAC OEMs talk about that. I don't know if you've seen any evidence of that in the channel.

Interesting, Gautam. We have not. And I actually asked that question. We were -- I mentioned that a couple of days ago, I was with our top distributors. It's something that when economies soften that you naturally look for. But we have not seen that. We haven't seen the mixing down. We haven't seen the trading down, replacing parts instead of entire systems. So for us, what we're doing is, I think the team did a superb job in the switchover and the new SEER unit. We are now laser focused on positioning ourselves for the refrigerant change, which gives pricing some both price and mix benefits to offset some of the destocking that we saw throughout '23 that we'll see into -- into the fourth quarter. But then I think when we start next year, a lot of that will be behind us as we position ourselves for the 454-B switchover. So no, Gautam, we have not seen any material evidence of that.

Okay. Just a follow-up to an earlier question on the pricing alongside the new units coming out in '25 or perhaps '24, as you mentioned. Just curious, do you expect order of magnitude, the pricing on those units to be comparable to what you saw with the SEER change this year? Or do you think it's enough cost is going to be designed out of the system such that we're not going to get whatever it was, 10% to 15% pricing lift ultimately? I know that's kind of -- there's been some talk about that, but I'm just curious what's your best guess on kind of magnitude of pricing opportunity with that new unit.

Yes. I think, look, there's been some skeptics on the -- whether we see the 15% to 20% over 2 years. We're very confident in that. We are going to increase price in resi. The normal price that we would have done anyway. We will continue to do that. As we go into next year, and we'll do it again in early 2025 as well. And then on top of that, you are adding some cost to the system for things like leak detection and sensors and some parts of the controls, and it would only be natural for us to increase price based on some of the additional protections that we're adding to the 454-B units. So we came into this year expecting price and mix benefit. I think it will turn out to be even slightly higher than we thought, around 10%. And we expect to see kind of similar orders of magnitude on price mix benefit with the 454-B unit.

Our next question comes from Brett Linzey with Mizuho.

Yes. I just wanted to come back to the business exit update slide. You noted the resi commercial fire public trading late spring. Was hoping you could just put a finer point on what the nature and structure of that transaction might look like as it moves to the public markets?

Brett, it could take a few different forms. Look, it could be a spin. It could be a split. We -- the example there would be J&J can view that was in the market recently. So that's an example that we benchmarked. We're preparing for different scenarios. And look, we've talked about a clean exit. We've talked about accelerating buyback. We've talked about our commitment to our investors to pay down debt. And what we're doing with this public company exit is achieving, yes, all of the above. So we'll work on the specific form as we get into early next year. The prep is the same effectively either way. And I'm very proud of the team because normally, a lot of this work would take longer. But the team is heads down working around the clock so we can be ready for public trading in the late spring of next year.

Okay. Yes, makes sense. And just to follow up on the international truck and trailer sales up over 20%, strong quarter. A bit of a moderation in the order book. What is your level of visibility based on backlog, based on incoming order rates as we flip the calendar here to '24?

Well, there's a couple of factors going on with international truck trailer. You also have a very rapid transition to electric going on there as well on truck. So I would tell you, we were pleasantly surprised with the low double-digit kind of increase -- the increase that we saw overall in international truck trailer. Orders were up 60% in the third quarter for our international truck trailer business, partly because of this transition to some of the electrification and partly because of the team has done very well in supporting the customers and the overall market demand. So we feel well positioned going into next year on the European truck trailer and even China has done well for us on the truck trailer side. And then North America truck trailer, despite people can sort of focus on some of the ACT numbers. But people said, look, 2023 ATP down mid-single digits for the year, our North American truck trailer will be up double digits. So we're taking a sober look at what ACT is saying for next year, but there's a lot of countervailing forces between, again, the shift to electrification, price, mix, and then this overall focus that we've had globally on length and more digitally enabled recurring revenues has yielded a lot of very strong results for us.

Our next question comes from Nigel Coe with Wolfe Research.

So I think you called out, I mean, we haven't explored this year, but the Toshiba performance, I think you called out, I think it's on Slide 4, I think it was maybe Slide 5 -- no, Slide 3. Toshiba Carrier performance remains strong. And we know Europe right now is really weak. We know that parts of APAC is really weak. So just curious what's driving the upside performance at Carrier, Toshiba Carrier?

Nigel, the financial performance at Toshiba Carrier has been really strong. A lot of that is driven by the synergies. We mentioned, I think, last quarter that we're increasing the cost synergies from a target of $100 million run rate to $200 million. It is helping us significantly expand our margins in that business. To your point, the sales in Europe for that business were a little lighter for Global Comfort solutions. But the performance overall for that business is really strong. And the key driver there is really all the synergies that the team is driving. And we are nowhere near the actual run rate yet. And so we expect to benefit from that for the next couple of years as that expands.

Okay. That's great. That's great to hear. And then I hate to go back to a question that's been asked a couple of times. But obviously, the HVAC margins this quarter were spectacularly strong when we even move back out the tax item. Obviously, 4Q, and I think 4Q originally was meant to be sort of similar to 1Q. It looks like it's coming in maybe a little bit weaker than 1Q. So just wondering, I'm assuming price costs would have been a factor in the HVAC strength there. I'm just wondering why that's not going forward to 4Q. So again, I mean, I know it's been answered, but maybe just a bit more color there, please?

Yes. Actually, I think that the HVAC margins for Q4 will be very similar to our Q1 margins. So I think they're very much aligned there. And as I mentioned in one of my prior answers, what we're going to see in HVAC in Q4, as we address the field inventories, we mentioned in our comments, we want the field inventories to end about mid-teens down versus the beginning of the year, a lot of it is going to happen in Q4. So we're going to see more downtime in our factories than initially planned. And that's going to impact some of the margins, of course, in that segment. We do expect price cost and productivity generally remain strong, but that is a headwind that we wouldn't have seen in the prior quarter, which is a destocking headwind affecting our factories.

Okay. And would there be some incentive spending to shift that inventory? Or is it just purely factory downtime?

No, this is factory. There is no incentive.

Our next question comes from Josef Nieto-Phillips with Jefferies.

It's actually Steve Volkmann here. We got a lot going on this morning, obviously, sorry about that. So my question is kind of a big picture one, Dave. Where do you think we are in the adjustment of the backlog? Does it go back to kind of historical levels? Or does it sort of settle in above historical levels? And sort of where are we in that process?

I think it goes back to historical levels. I think what happened over these last couple of years is just very unique that as you saw some of the supply chain challenges that -- and the underlying demand was strong. The consumer has been strong. You saw a lot of people getting in line to make sure that they had their orders positioned for when they need them. I mean, for example, light commercial. Light commercial for the school year, a lot of those replacements they want to see happen during the summer time. So people are making sure that with the supply chain uncertainty people are getting in the queue to have their position protected I think what you've now seen is in the shorter-cycle business, generally a return to more historic levels. With some of the longer cycle businesses like for us, commercial HVAC, we're still -- again, where backlog is up 40% on a 2-year stack. We're still elevated lead times and elevated backlog levels. I think that you would expect that to start to normalize. But if the underlying demand, which depending on the vertical remains strong, you'll continue to see very strong growth in some of those key businesses. So I think there will be a leveling. That's why we don't get overly fixated on quarter-to-quarter orders because they can swing wildly much more than they ever would have in the past. We talked about them being up 40% or down 40%. We don't swing with those. We look more at our backlog levels and our lead time to make sure that we see the strength that we expect to see.

Got it. And do you think we'll get sort of more normal by the end of '24? Or does it take longer than that?

No, I think that's about right. I mean I think that some of the shorter-cycle stuff is starting together. We're seeing more normal lead times in resi. I think that's going to happen for Viessmann Climate Solutions, that they'll start to get their backlogs back to more normal levels as you get into like the 1Q type timeframe. And then it just goes back to basics. So I think when you look at sort of the longer cycle stuff that's sort of by the end of '24, the shorter-cycle stuff is essentially there.

Super. And then Patrick, as this happens, is there a chance to generate net income or free cash flow above net income for another year?

If we -- it will -- of course, it will depend on what's happening with our working capital. And I think so far this year, we've done really well compared to the, obviously, compared to last year generally a whole lot more. We would have to make a significant additional dent into working capital. Clearly, that's our objective, but obviously not ready to commit to that before February when we provide guidance for next year.

And our last question comes from Andrew Obin with Bank of America.

I really appreciate you guys fitting me in. Just a question on light commercial and just business mix, right? Because the growth in light commercial has been so spectacular. It's a good margin business, and then in the face of resi declines and sort of stadia growth in Applied. As you look at North America, what does the business look like right now, sort of the mix between resi light commercial and applied? And how structural and sustainable is this mix going forward? Because clearly, it's quite good for your margins.

Well, look, the -- obviously, resi's far bigger business than light commercial. And to your point, Andrew, light commercial has been, I know, far better than many thought that we're modeling it coming into the year, and we've been very pleased with the performance there. So resi is the biggest business, followed by commercial, followed by Light commercial. We think with some of the destocking that we'll see in 4Q, we're kind of in the switchover to 454-B in resi. We think there, we know volumes down mid-teens, sales down kind of mid-single digits for resi. We start to see recovery as we go into next year in that business. Light commercial is going to face some tough compares. But as I mentioned, a lot of those verticals remain very strong in light commercial. And they're also doing what the rest of the business is doing is very much leaning into connected devices and the aftermarket opportunity. And frankly, it's a bit nascent in that space, and we think there's a lot of opportunity there. And then I think commercial, we still are dealing with very significant backlog in the commercial side. The controls business has done extremely well. Aftermarket is doing very well, double digits there and with further growth there. So we think that with the strong backlog, we think eventually, lead times will kind of come back to normal for the North American commercial business. But they're still elevated, still strong backlog. So they're positioned for growth as we get into next year as well.

And just a follow-up question on commercial. Are you guys seeing the impact from mega projects? Because my understanding is that these semiconductor fabs, ABE factories require a lot of air conditioning, HVAC data centers. Can you just talk about what you're seeing about growth and visibility in these high-growth verticals on the commercial side?

Yes, Andrew, that's been very encouraging. We've done very, very well on many of the mega factories, and that includes both data centers. It includes factories associated with the Chips Act and some of the new construction activity there with all the Gen AI type activities. So we have solutions not only that we're doing more creative solutions with the high temperature and very high temperature heat pumps we mentioned. We've introduced new offerings like our mag bearing design for the Applied. We have a business that we bought a couple of years back called Nlyte that really complements our ALC controls business so we can provide sort of holistic controls to identify with specificity, where is the heat getting generated in a data center and how we dissipate that heat most efficiently. It's effectively an integrated AI tool in and of itself. So we love to see the continued construction with these mega projects, and we've gotten more than our fair share of new wins there.

That concludes the question-and-answer session. I'd like to turn the call back over to Dave for closing remarks.

Well, look, let me just thank all of you, our investors, for their continued confidence, and let me thank our team. We have folks working tirelessly while we perform and continue to transform the business. So my hats off and thanks to the team. It's just not only working so hard, but working so well and together as a team. And with that, we'll conclude the call. And of course, Sam will be available for the rest of the day to everyone. Thank you all.

Thank you for your participation. This does conclude the program, and you may now disconnect. Everyone, have a great day.