Trane Technologies plc (TT) Q2 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Ingersoll-Rand Second Quarter 2014 Earnings Conference Call. [Operator Instructions] Please note, today's conference is being recorded. I would now like to hand the conference over to Janet Pfeffer, Vice President, Investor Relations and Treasury. Please go ahead.

Thank you, Karen. Good morning, everyone. Welcome to the call. We released earnings this morning at 7:00 a.m., and the release is posted on our website. We'll be broadcasting, in addition to this phone call, through our website at ingersollrand.com, where you will find the slide presentation that we'll be using this morning. This call will be recorded and archived on our website. If you'd please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our SEC filings for a description of some of the factors that may cause actual results to vary from anticipated. This release also includes non-GAAP measures, which are explained in the financial tables to our news release. Now let me introduce the participants in this morning's call: Mike Lamach, Chairman and CEO; Sue Carter, Senior Vice President and CFO; and Joe Fimbianti, Director of Investor Relations. With that, please go to Slide 3, and I'll turn it over to Mike.

Great. Thanks, Janet, and good morning, and thank you for joining us on today's call. In the second quarter, we delivered earnings per share of $1.13. There was a small amount of restructuring in the quarter, less than $0.01, but this quarter's reported and adjusted EPS are identical. That's at to the top end of our adjusted earnings guidance range and a 22% increase versus the second quarter of 2013. Revenues were $3.5 billion, up 4.3% versus last year. Revenues were consistent with our guided revenue range of up 4% to 5% for the quarter. Orders were up 5% in the second quarter, with Climate up 6% and Industrial up 2%. Adjusted operating margin, which excludes restructuring from the prior year, was up 150 basis points. Climate margins increased 150 basis points. Industrial margins were up 30 basis points. Pricing exceeded direct material inflation, as it has each quarter for more than 3 years. Operating leverage was about 50%, with 43% leverage at the segment. We repurchased 4 million shares in the second quarter. Overall, a very good quarter with revenues about where we thought they would be, an excellent operating leverage on the revenue growth, particularly in the HVAC businesses, both residential and commercial. Now Sue will walk you through more details in the second quarter. I'll then take you through our third quarter and 2014 outlook.

Thanks, Mike. Starting at a high level, our bookings for the quarter were up 5%. Revenues were up 4%, and our operating margins, without restructuring, were up 150 basis points year-over-year. Reported earnings per share were $1.13 versus midpoint guidance of $1.10. We were a little better on price and mix and $0.01 lower in restructuring. Let's move to Slide 4. Orders for the second quarter of 2014 were up 5% on a reported basis, and excluding currency. Climate orders were up 6%. Global commercial HVAC bookings were up low-single digits. Transport orders were up mid-teen. Orders in the Industrial segment were up 2% on both a reported basis and excluding currency. Let's go to Slide 5. Here's a look at the revenue trends by segment and by region. The top half of the chart shows revenue change for each segment. For the total company, second quarter revenues were up 4% versus last year on a reported basis and excluding currency. Climate revenues increased 4%, with commercial HVAC revenues up low-single digits and transport revenues up high-single digits. Residential HVAC revenues were up high-single digits. Industrial revenues were up 4% on a reported basis and excluding currency. I'll give more color on each segment in the next few slides. On the bottom of the chart, which shows revenue change on a geographic basis, revenues were up 3% in the Americas, 16% in EMEIA, and Asia was down 2%, all excluding foreign exchange. The lower revenue in Asia was mainly driven by geographies outside of China. China was about flat, excluding currency. Now let's go to Slide 6. This chart walks through the change in operating margin from second quarter 2013 of 11.4% to second quarter of 2014, which was 13.1%, an increase of 170 basis points. This chart is on a reported basis. We've clearly spiked out the impact of restructuring costs for you, which was 20 basis points of tailwind year-over-year. Volume, mix and foreign exchange collectively were 60 basis points positive versus prior year. Our pricing programs continue to outpace material inflation, adding 50 basis points to margin. As Mike said, we've been consistently positive on this measure for more than 3 years. Productivity versus other inflation was a full margin point positive impact in the quarter. Productivity ramped up in the quarter as we got past all the weather-related impacts of the first quarter and saw benefit from the restructuring done in late 2013 and earlier this year. Year-over-year investments in restructuring were higher by 40 basis points in total. In the box, you can see that, that was comprised of 60 basis points of headwind from investments, mainly in IT, channel expansion and new product investments, and there was a 20-basis-point benefit from lower restructuring costs. So if you prefer to look at this on an adjusted basis, adjusted margins increased a net of 150 basis points versus the 170 basis points on a reported basis. Leverage in the quarter was excellent at almost 50%, excluding restructuring from last year, and 43% in the segment. Climate's leverage at 48% was led by the HVAC businesses, particularly in North America. Let's go to Slide 7. The Climate segment includes Trane commercial and residential HVAC and Thermo King transport refrigeration. Total revenues for the second quarter were $2.7 billion. That is up 4% versus last year on a reported basis and excluding currency. Global commercial HVAC orders were up low-single digits. Orders were up in the Americas, Europe and Asia. Commercial HVAC revenues were up low-single digits. Revenues were up high-single digits in Europe, up low-single digits in the Americas and down in Asia. Commercial HVAC new equipment revenues were down slightly, while HVAC parts, services and solutions revenue were up mid-single digits versus prior year. Growth in worldwide unitary equipment revenues was more than offset by lower applied revenues. Thermo King orders were up mid-teens versus 2014 second quarter, led by increases in truck, trailer and bus. Container orders were slightly lower in the quarter. Thermo King revenues were up high-single digits with truck and trailer revenue up low-single digits and marine container revenues up significantly. Residential HVAC revenues were up high-single digits versus last year. Unit volumes were also up high-single digits, and mix was positive in the quarter. The adjusted operating margin for Climate was 14.2% in the quarter, 150 basis points higher than the second quarter of 2013 due to volume and productivity, partially offset by inflation. Now let's go to Slide 8. Second quarter revenues for the Industrial segment were $794 million, up 4% from last year's second quarter. For the Industrial segment, excluding Club Car, revenues were up mid-single digits, and orders were also up mid-single digits versus last year. Excluding Club Car, revenues in the Americas and Asia Pacific were up, while revenues in Europe, Middle East and Africa were up over 20%, part of which was positive currency impact. Revenues in the air compressor business were up mid-single digits, with strong gains in oil-free products and parts and services. Club Car revenues in the quarter were down low-single digits, while orders were down mid-single digits versus prior year, as both markets were down in the quarter. Industrial's operating margin of 16.4% was up 30 basis points on higher volume, productivity and pricing, partially offset by inflation and investment spending. Let's go to Slide 9. Working capital as a percentage of revenue was 4% of revenue in the quarter. The increase versus prior year is from higher receivables and inventory, partially offset by higher payables balances. Days sales outstanding is up mainly due to mix of business. Delinquency is unchanged from prior year. On inventory, we have been intentionally increasing stocked inventory levels of key assemblies in order to ensure supply, particularly in the higher selling season. Year-to-date, June free cash flow was $98 million. Working capital will come down in the second half to a level closer to 3% of revenues based mainly on timing of revenues. May and June are our highest 2 months sales volume, and given our DSO is about 60 days. That drove higher working capital balance at the end of the second quarter. And let's go to Slide 10. We repurchased 4 million shares for approximately $200 million in the second quarter. Year-to-date June, we have spent $1 billion in share repurchases and repurchased about 17 million shares. Our forecast for the year remains to spend between $1.375 billion and $1.475 billion on repurchase, with $400 million to $500 million of that coming from free cash flow. And with that, I'll turn it back to Mike.

Great. Thank you, Sue, and please go to Slide 11. Before we review the forecast, I want to take a few minutes to mention some very important new products the Trane commercial introduced in Europe at the end of June. This is a milestone for Trane since we're introducing 5 new chiller products at the same time. Products included centrifugal, air-cooled and screw chiller designs and cover a broad range of sizes and market applications, including education, healthcare, lodging, large commercial buildings and process cooling in Europe. All these new systems are available with advanced controls and designed for cost effectiveness and optimal energy efficiency for both full load and part-load performance. The chiller in the upper right side of the slide, the Series E CenTraVac, is truly a breakthrough technology. These products are designed for cooling large commercial buildings and are up to 10% more energy-efficient for the next best chiller available in this tonnage range. The true innovation is that the E Series is the first commercialized chiller to use an ultra-low global warming potential HFO refrigerant. The new refrigerant allows the E Series chillers to continue to utilize Trane's highly reliable and efficient direct rise of low pressure designs that have made Trane chillers the global leader in centrifugal chillers. I believe we are gaining momentum in our capabilities to introduce new products in all of our businesses. This will help to improve our growth rates as we see the slow recovery of our commercial construction and markets we're in. Now let's move to the forecast, and please go to Slide 12. In the aggregate, markets were about where we thought they would be, some a little better and some a little weaker. Our second quarter revenues were in line with our guidance. Dodge put in place forecast for 2014, did not change much in the latest update. In total, the 2014 Dodge forecast is still up about 8%. Relate this to our North American business, commercial and industrial buildings tend to use more Unitary equipment, while the institutional markets use more Applied equipment. The commercial and industrial forecast was unchanged at up 18% versus 2013, while the institutional forecast still is forecasted to be down 1% for the year. Within commercial and industrial, the vertical with the largest growth is still warehouses at over 30%. They have little HVAC content. The verticals for Trane, our office and bank, retail and manufacturing, which are all up, but at a more modest rate. Within institutional, government is expected to be down over 20%, while education and healthcare are forecast to be slightly down in 2014. The only vertical in institutional forecasted to be up in 2014 is amusement, was not a key vertical for Trane. We expect Europe, Middle East and Africa to be up mid-single digits for the year. Asian HVAC markets are expected to be up low-single digits overall, with China up low to mid-single digits. The remainder of the region will be fairly flat. We've seen impact, for example, in Thailand with the political unrest there. The full year outlook for residential HVAC markets is still for mid to high-single digit growth in the Unitary volumes, industry volumes. Transport markets had a good start to the year, particularly in Europe and in marine. Bookings growth has been front-end loaded for both trailer and container. We expect booking rates to moderate in the second half. We expect the full year North American trailer market to be flat, slightly up on a unit basis, but up high-single digits on a dollar basis due to the mix of CARB-compliant product. Industrial markets were somewhat improved in the quarter. The latter half of the quarter showed some recovery in China. Based on the first half results of our outlook for the second half, we are raising our full year revenue. We see revenues up about 4% from the prior guidance of about 3% to 4%. Actually, not much changed in the aggregate to our Climate revenue outlook. The change was in Industrial, where we are raising revenue expectation. Our updated forecast is for Industrial to be up 2% to 3% versus the prior forecast of flat to up 2%. The increased outlook was in our core industrial businesses, as gulf markets are expected to be flat, down for the year. Please go to Slide 13. The third quarter guidance refers to the middle column on this chart, although we've included quarter 4 on the chart just to save you some math. Third quarter 2014 revenues are forecast to be up approximately 4%. We expect growth will be stronger in Climate than in Industrial, but both should be in the low to mid-single-digit range. Third quarter GAAP continuing earnings per share are forecast to be in the range of $1 to $1.04. Restructuring costs are expected to be about $0.01 in the quarter. So on an adjusted basis, the EPS range is $1.01 to $1.05 The current situation in Venezuela is evolving. We are continuing to evaluate the impacts that have included about $10 million or about $0.03 per share, foreign exchange losses related to Venezuelan currency in the third quarter forecast. We're assuming an average share count of 273 million shares, a tax rate of 25%. There's an EPS bridge versus last year's third quarter in the Appendix for your reference. For the full year, as I said, we see revenue growth of about 4%. We are raising our full year 2014 earnings outlook to a range of $3.13 to $3.21 on a reported basis. Prior comparable range was $2.95 to $3.10, which included $0.10 of restructure. For the full year, we now expect to spend about a $0.05 in restructuring. So $0.05 of the change in guidance and some change in restructuring outlook, and recall the $0.03 foreign exchange that we have in for Venezuela in Q3 guidance, which flows through to the full year. The core earnings forecast was going up by about $0.13 at the midpoint. There's no change for the full year average share count guidance of 275 million shares, with a tax rate of 25%. So in closing, we're pleased to have delivered above our earnings commitment in the second quarter, with excellent performance in the segments. I continue to feel good about our positioning and our focus as we head in the latter half of the year. And with that, Sue and I will be happy to take your questions.

[Operator Instructions] Our first question comes from the line of Julian Mitchell from Crédit Suisse.

I just had a quick question on the margin guidance by segment for this year. You've obviously updated the revenue assumptions. You talked about Climate before, up about 40 to 80 bps, Industrial flat to up 20. How do those look now to you?

So Julian, when we look at those, we're leaving the Industrial segment at flat to up 20 basis points, and then on Climate, as you pointed out, we were at 40 to 80 basis points. And it now looks like about 80 to 110 basis points. So we did take that up with the guidance increase.

And then just within the margin bridge sort of in aggregate, the productivity number was very good in Q2. Do you see that as kind of a good sort of ongoing rate balance of this year and when you look out into sort of '15 and '16? Just because I think you're only halfway covered on the value streams of the cost base and so on.

Julian, the thing that is important there is the pipeline that we measure. And as I've said in the past, we try to keep that pipeline between 110% and 150% of what's required, understanding that there's timing issues and some things don't work that were planned. So the health of the pipeline, it looks like it's still intact, both from a materials perspective, as well as a direct and indirect labor perspective. So I would say that we're not forecasting any real changes in productivity. However, that's always subject to the pipeline and the timing of when projects actually hit.

Our next question comes from the line of Andrew Obin from Bank of America.

So very pleasantly surprised on industrial growth revision. Can you give us a little bit more detail as to what's really happening by region in North America, Europe?

Well, the core industrial markets, which is non-Gulf, are doing better than we anticipated. Europe clearly is better than we anticipated across the board. As we mentioned, we're up 20% in EMEIA in the quarter, and the order book there looks great. North America, a little bit stronger, but again, stronger parts and services as well. China, which showed a little bit more strength in the latter 2 months of the prior quarter, has a decent outlook for the balance of the year in terms of the pipeline. But there, frankly, Andrew, it's large equipment orders typically that become more of a timing issue as to whether it's fourth quarter or first quarter of next year. But all in all, we felt that the core industrial businesses deserve a little bit of a fresh look.

And then just a follow-up, how sustainable is the EMEIA's strength? And what's driving the strength? Is it market share gain or any particular markets? Because that looked very strong.

Yes, it's actually mostly in Western Europe as well, too. So it's a combination of another thing, Andrew. I wouldn't just pick one, but clearly, we've done well with the efforts of the fast feet-on-the-street in the region. We've got, I think, great product at a good price point in the region. I think that oil-free has been a significant gainer for us there as well and for that matter, across the globe. So no, I don't think that 20% growth rates are something to plan on in Europe going forward, but we're pleasantly surprised to see that we have a great quarter there.

And Andrew, let me just add one thing on there. For 2014, we're expecting revenues in EMEIA to kind of be mid to high-single digits for the year.

Our next question comes from the line of Joe Ritchie from Goldman Sachs.

It's a good quarter. It seems like pricing clearly has been strong for quite some time, but may have surprised to the upside this quarter. Europe was good, but you didn't really take up your growth expectations significantly. It seemed like a lot of the guidance raise was driven by the margins, particularly on the Climate side. And so I guess, just what gives you the confidence at this point in raising the guidance for the back half of the year?

So Joe, as we think about the guidance and what we're seeing in the markets and our performance, we're obviously pleased with what we've seen through 6 months, and what we've seen actually gives us some confidence for the year. As you pointed out, we're still in a low-to-moderate growth environment. And so as we looked at the revenue, the outlook is only a little bit higher, and most of the earnings guidance is from higher operating performance. The enterprise leverage is in the mid-40s, and the segment leverage is in the mid-30s for the revised guidance. And again, as we looked across at the businesses, the performance that we have, what we see on pricing versus material inflation, productivity, et cetera, we thought this was the right place to land.

Okay, that's helpful. I guess, one follow-up on the cadence for 3Q and 4Q, particularly as it relates to the incremental margins. It seems like there's a step-down implied in your guidance for the incremental margins for 3Q and then a step back up in 4Q. I just want to make sure I'm thinking about that the right way. And if so, what's causing that in 3Q versus 4Q?

Well, I think as you look across the quarters, I mean, I think we're still seeing in the third quarter that prices is going to offset direct material inflation, but at a lower rate, also the same for the fourth quarter in terms of the overall businesses. And then one of the other things that you see in terms of that leverage is the amount of corporate expenses that are in the fourth quarter.

That corporate last year, as we were really truing up half the spend, there were some stock-based comps, benefits, changes that came in, and really in the fourth quarter, higher than the normal run rate. So there's a pickup there in the fourth quarter. We also had a flood in China in our industrial businesses, which hopefully won't repeat again this year. So that would be another reason why the fourth quarter leverages look so much higher than the normal.

Our next question comes from the line of Jeff Hammond from KeyBanc.

Just wanted to kind of focus on the Applied market, and I think you said the Dodge data is still being pretty choppy, but I'm just wondering what you're seeing in the quoting activity? Any signs of inflection or kind of building momentum into '15? And then within that, if you could just kind of update us on your VRF strategy relationship with Samsung and how you think VRF competes or doesn't compete with the chiller-based systems?

Well, there's a lot there Jeff, as always. So when you look at the Applied markets in general, the market in quarter one, this is the North American market, which is where the data's most available, was down about 3%. Last year, it was down 4% in total to market. Second quarter was down a little bit lower. The market was down 4%, but the market expectation, the third-party prognosticators here think that it will come back to 0 for the full year, which implies a pretty sizable third and fourth quarter pickup. Conversely, in Unitary, the market last year was about 5%. First quarter was strong at 7%. Second quarter was actually 5% again, and the prognosticators would call that down to 4%. I think it's more likely that you're not going to see -- you're going to see a ramp-up and an improvement in Applied market in the back half of the year, probably not to the extent that it's being prognosticated. And then I think on the Unitary side, those are very strong. If you even take the first 2 quarters for us, our bookings in Unitary were up double digits for the first 2 quarters. And the momentum there certainly will slow, but not to the extent to bring it down to where the market is stalling it. So I think that you'll see more gradual turning of Unitary and Applied as we go forward. Now specific to VRF, remember, our strategy is multifold. We produce some VRF in our other factories. We have an arrangement with Samsung, as well as 2 other VRF manufacturers that we utilize for components. So all in, our Unitary business is doing well across the world, which includes VRF. And of course, our RVF growth rates are growing much faster than the industry VRF growth rates because of the fact that we're working off smaller numbers there. But just as the ductless growth rates are increasing, so too is the ducted component globally for us. So from a Unitary perspective, we've had really good growth across the world in Unitary through the first 2 quarters, both in ducted and ductless.

Okay, great. And then just, I don't know if I missed this, can you give us an update on what think corporate is, and just maybe what the run rate is exiting '14? And is that kind of how to think about the go-forward run rate?

So Jeff, what we've talked about for corporate spending was a range of around $200 million for the year. What we're targeting about today and what we're thinking about is a range of around $200 million to $220 million depending on how some of the things that Mike referenced earlier like the stock-based comp, the benefit plan true-ups and investment spending comes in for the year, but -- so that gives you sort of a $50 million to $55 million a quarter range for corporate expenses. But as we look at that, and I talked about $200 million to perhaps $220 million, I want to be clear that the restructuring spend and the stranded cost that were taken off from the Allegion spin, were taken out in late 2013 and early 2014. If the number was above the $200 million range, it would be because we had decided to do more investments or we had items, again, in stock-based comp or in benefit plan true-ups.

Our next question comes from the line of Steve Volkmann from Jefferies.

I'm wondering if we're getting any better visibility into the next iteration of SEER requirements here in the states and how that might impact your business, whether we might see some pre-buy or perhaps that's not an issue? Just any update on that.

Well, I think to your point, it's probably gotten more murky as opposed to less -- more clear. The standards really, at this point in time, as you probably are aware, are a bit up in the air again. We've got activity happening in the next couple of quarters, where DOE will lead some panels to go through the enforcement of changes to SEER standards in 2015. But those really won't become rules sometime in 2015, so it's very difficult to tell what the impact would be. I would say probably what you won't see is a quarter or 2 ago, the thought was that those rules would be in place, you might see some last-minute manufacturing of 13 SEER systems. And I think that, that probably will not be the case, because I believe that you'll probably see 13 SEER systems manufactured and sold throughout the country sometime into or through 2015. That's a bit more speculation on my part.

Okay, great. And then can you just comment on where you think inventory channel -- channel inventory is? And whether it might need to be adjusted going forward?

Are you talking about residential HVAC or what part of the business? Assuming you're on mute at this point, I'll try, so I'm going to assume that's residential HVAC. And they're at about normal levels at this point in time. We're running higher bookings in the first quarter, shipped a lot of those bookings in the second quarter and towards fairly low at the beginning of the second quarter. So fairly normalized levels for us, which tends to be a little bit lower than some of what our industry competitors hold. And if you go back over a long period of time, largely, we've been trying to do a better job on cycle times from the factory to the dealer to allow distribution to actually hold less inventory at different times during the year. So to answer your question, in short form, fairly normalized.

Our next question comes from line of Andy Casey from Wells Fargo Securities.

Just a couple of follow-ups, a lot's been asked. Within the industrial order improvement asking, I think it was Andrew's question, a little bit different, are you seeing any specific pockets of strength like type of customer as opposed to region?

Well, yes, you do see some. I mean even in China, as you look through it, as an example, you wouldn't see strength in areas like some of the heavy metals businesses in China. But you -- so you would see some in some of the verticals that we would play more into. So of course, food and beverage and nuclear would be a big market right now in China, where we're doing well. It's those markets, but staying away from a lot of the sort of heavy industry, overcapacitized places that China has outlined would be an example. In the U.S., it's a bit broader-based than that. And then from a technology perspective, certainly, as we said, oil-free parts and services are stronger. And frankly, the parts and services piece of that is consistent with some of the investments that were made early in the year, around putting some additional feet on the street, both in terms of selling capability, but also in terms of technical service, ranks and pulling some pockets to get there.

Okay, great, Mike. And then -- and returning to a prior question, again, that I think last quarter, you called out some improvement in the Applied unit order growth within the Climate orders. Did you see that continue? I know what you said about the industry forecast, but I'm just wondering within your orders, did you see that continue?

Yes, we have, and we actually have what we believe is a much more reliable proprietary view of that, which is a pipeline view, which goes all the way from an early conversation with a customer or the identification of a project all the way through to following it through a pipeline with a percentage estimate of close and so on and so forth. And so you do see a larger pipeline going through. But again, I don't see that there is sort of an immediate inflection point in Applied that some of the third-party market data points would suggest, I think, some more gradual improvement through 2015 with a more gradual moderating in the Unitary business in 2015 as well. But yes, we're seeing that as well.

Our next question comes from the line of Jeff Sprague from Vertical Research.

Could we just get a little bit more granular, first, on kind of the price side, Mike? Is there any real distinction where you're seeing it, I would guess resi versus kind of Unitary and Applied? But can you just put some perspective around what's going on in pricing in general?

So I suggest let me give a broad overview on pricing and what we're seeing. So from the perspective of being overall, we still expect the pricing environment to be fairly modest in 2014. So about 50 basis points of price. We still expect to be able to more than offset material inflation. But we think towards the back half of the year, as I said earlier, that the positive gap will look more like what we saw at the end of 2013, which is more in the 20 to 30-basis-point ranges as opposed to the 50-basis-point range that we're seeing. And I think that across the segment, we are seeing favorability and -- but to your point, resi was a little bit -- was part of the stronger piece of the price.

Jeff, actually, we had across-the-board. So if you took Climate, both a resi and commercial, and then split up commercial by region, by product, we actually had positive price in all areas that -- as we did in industrial falls. So there weren't any big gaps you just alluded to. One of the bigger surprises was that residential was actually a price leader for us in the quarter.

All right. And then, Mike, could you just address kind of the comment or perhaps, Sue, on kind of inventory running higher to meet demand? It sounds a little counter to what we've been hearing on better flow through the factory and better reaction times and the like. Are you hitting some diminishing returns there or is there something in particular in the outlook that you're trying to prepare for?

Well, it's a very inexpensive insurance policy right now with working capital rates where they are in the company and areas where we've got long lead items. A great example might be diesel engines for TK would be a perfect example of that, with a really strong bookings backlog. And although we expect it to moderate, we really don't want to run out of engines, which can take 12 weeks to come across the water to get here. That would just be an example of that. So -- and then selective throughout the business. But if you'd go to our tools business, there's 25 tools that we just absolutely will not stock out of. And there's been a great activity in that business, particularly around some of the new product launches with our electronic power or electric Power Tools that actually have interfaces, electronic interface, then to customer production systems. That's been a big winner for us. That's not something we're going to stock out of. And so, again, it's really building in advance. There's also campaigns that we're running in certain areas of product growth team are spearheading. So we talked about the 6 product growth team within areas where they've got to deliver a plan to spearhead something into a particular vertical market or a particular region. We're making sure that the buy up [ph] order plan's consistent with what they're trying to do. So in other words, we're trusting that those product growth teams are going to be able to action out what it is we're trying to do. Worst thing we want to do is have them do that, not be able to support with product. So it's selective, not across the board. It's got nothing to do with the value stream. It's got to do with where there are pockets of growth and whether the unique opportunity is being able to take advantage of that and certainly in really long leads, 12 to 16-week items that come in from suppliers, we want to make sure that we're not running out of those.

Our next question comes from the line of David Raso from the ISI Group.

X the corporate expense year-over-year, the incremental margins that you're targeting around 30%, 31%, can you give us some puts and takes to how to think about the incremental margin moving forward just trying to look out to '15, just thinking about further productivity improvements? I was happy to see the compressor business, which is usually better incrementals, starting to show some life. Then they also -- maybe Thermo King in North America starting to run up against some tough comps. So I just, maybe just big picture, get your thoughts on how we should think about the segment incremental margins moving forward?

Yes, David, for 5 years, we've been running somewhere in this 40% to 50% incremental margin range. I haven't calculated it lately, but I don't think we rode it as much in the last year, so. And at some point in time, logic prevails that you're going to be normalizing back toward something that looks like gross margins of the company. Of course, we're trying to drive gross margins of the company up, and worse, without having higher incrementals. But any time we do above 30% we're truly digging in beyond variable cost. We're digging into the fixed cost base of the company. So we guided initially to 25% allowing for some breakage in the business, and pipelines that may not materialize. The first 2 quarters, the pipelines did materialize, and we were able to take advantage of the opportunity to manage away the risks. But that's not always the case, and that's why I caution you and the listeners on the call that a good number tends to be the gross margin of the company. And really, the safer number is the gross margin of the company less the breakage that normally is involved in these sorts of things.

Just trying to think a little bit. You have the lower share count exiting the year than your average share count. When it comes to things like the tax rate for next year, still think of it as 25% is a good base case?

Actually, I'll pass it to Sue because I was talking specifically about segment operating leverage. So...

Sure. No, I still -- I was as well. I was just trying to think of the other puts and takes.

Okay.

Right. So David, as I think about share count and I think about tax rates, as we're looking at the -- I'll give you the example, for the second quarter, we got about a $0.10 benefit coming out of the share count and a headwind out of the tax rate of about $0.15. And for the full year, you're going to have the same story of -- you're going to have more of a headwind coming off of tax than the benefit from shares. So as I look to what happens next, I mean, obviously, we need to go through and do our operating plan. We need to look at the areas where our income is going to come from in '15 and beyond. But I think from an overall basis, there isn't a reason to think that it would be a lot different than sort of the mid-20s type of range, which is sort of where we've been at for a while. So again, in '14, you're going to have less benefit from shares than the headwind on taxes at around 25% for the year.

And then that same spirit, thinking about the repo for next year, just again, I know it's only July, but framework, this year, roughly $1.4 billion. I mean, just trying to think of a normal framework for '15, just given your cash flow and balance sheet. I mean, is the $800 million, $900 million kind of number the right way to think about it, just framework for continuing repo going forward?

I think as we think about it, I would say let's hold onto so much about 2015. And so we got, later in the year, see more of the activity and continue to evaluate where we are.

Our next question comes from the line of Steven Winoker from Sanford Bernstein.

Could you comment on M&A, Mike, and consolidation? We've talked about it a lot in the past. What's your current thinking on that and where we are at this point in time?

Yes, well, I mean, we always have the mirror we hold up, which is share buyback. And you can do something that's more accretive on EPS, margin or ROIC. We'd probably do it if it fit right into a core business, meaning that it's new technology in a related business that we can use our existing distribution to do. Or vice versa, we might have a gap in distribution, and any distribution actually do more of what we can do today. So -- but frankly, if we found those things we would do and do them, Steve. And I think that the key there is being selective, as we have been and not paying ahead of your synergies.

Okay. And then just to follow up your answer to the other question on incrementals and fixed cost reduction, it looks like your restructuring opportunity ebbs and flows here, but given how much of the cost base you still have to address on the Lean side as well, I mean, can you describe this sort of longer term restructuring runway that's left inside the existing portfolio?

Okay. As it relates to factory utilization, which I think is a bit where you're going with Lean, you can think about the fact that we've taken so much, that physical footprint out, which has given us that 40%, 50% operating leverage over these past 5 years. We feel pretty good about the factory footprint at this point in time. And although there's always a thing or 2 we might consider doing, it's not like we're doing any wholesale changes to that, where we're very well utilized across the business. And so Lean at this point in time is more about making sure that as we see business pick back up, we have the capacity, we have the ability to handle more throughput due to the same fixed cost base. And that, again, will help ensure that we're getting operating leverage and at least equal to the gross margins of the business, which will be the plan. That's how I would think about it.

Our next question comes from the line of Steve Tusa from JPMorgan.

Just on HVAC first, what percentage of your sale this year do you think are going to be 14 SEER and above? And using kind of a rule of thumb is, I don't know, 15% to 20% higher price to 14 vs 13 SEER, is that fair? And then just on HVAC, the commercial stuff you talked about, the Applied markets, it doesn't sound like anything in Climate is going to get worse in the second half. It actually sounds like maybe things could get a little bit better, but you have a consistent growth rate there. Maybe just talk about that dynamic as well?

Yes, Steve, the first part of your question, 14 versus 13 SEER, the industry sort of prices somewhere between 19% and 21% difference between 14 and 13 with the expectation, I think, that when 13's gone, you'd find probably more cost reduction on 14, and therefore probably a lower differential from what was 13 to what would then be 14. I don't have a breakdown in front of me, Steve, on 14 through. We've had a nice share gain there, so it plays to our strong suit because we are seeing a mix-up of particularly, as you're looking at '16 and above, we're seeing a nice action there for us. And then to your point, we're mildly optimistic. I mean our forecast for Applied, Unitary or commercial HVAC, in general, would tell you that we expect a stronger back half than first half. And so it's marginally stout, but it's a better second half than our first half. And that's, again, going back to this point, that the market prognosticators show that happening. We see that happening, albeit we think at not the various steep inflection points that are more forecast out through the industry data.

And any way to quantify that pipeline comment you made, whether it's bidding activity? Or I mean, any numbers or high-level numbers to quantify that, and help us understand how -- because I think JCI made the same comments about how optimistic they were maybe carried this morning as well in North America, but it's kind of hard to -- for us to get our hands around it. And any kind of high-level data around that pipeline?

Yes, Steve, actually, interesting for us is there's 2 things going on. One is the pipeline improving, but there's a second activity here, it's making that a little bit difficult to give you an exact answer, which is that in most of our Climate businesses, there's a market coverage initiative underway, which is looking to make sure that whether it's by ZIP code or by country or by region or places we get our hands on it, what's our coverage ratio of the market? How many projects are we finding? What's the density of our revenue per available square foot of HVAC content? And what that's doing is driving investments into these markets, additional salespeople for market coverage. So you've got a combination of market coverage and improved pipeline giving you a larger number than I think what's actually going to be reported by some of our competitors, but I don't want to give you a wild number on that. A year from now, I think we're a bit more normalized there. That'd be a number that I hope we could hope to report to you a bit more would be a leading indicator on pipeline. But I would not be comfortable to throw out a big number at you today.

Our next question comes from the line of Deane Dray from Citi.

Mike, if we could stay in that the residential mix topic? We did a survey earlier this quarter, shows a pretty interesting demand characteristics, clustered demand, both at the very low end, the 13 SEER, but also a lot of interest at the high end, and you just mentioned at the 16 SEER and above. So how are you positioning the portfolio today as towards that higher end? You have all of the SEER levels represented. And how do you expect that demand for both the highest and the lowest then to play out?

Yes, Dean, it's mixing up, which is good always for Trane and for American Standard's, it's good for us. Our strategy has always been to make sure that we're shoring up sort of the 13 and 14, which I kind of see as one bucket, and then really however you play 15. But 16 and above would be the higher efficiency systems that always has been a strength, continues to be a strength, both in the dealer base, but also in the product portfolio. So the key there is we want to continue to have that historical Trane strength, American Standard strength in the highest resistance. But we're making a lot of progress in the 13, 14 as well. And so it's really playing both.

That's helpful. And in showing us these 5 new chiller products, it begs the question, what type of growth investment have these chillers? And just broadly in terms of new product introductions, what type of growth investment is this involved? And where do you stand on your product vitality?

Yes, that set of investments there would be somewhere north of $100 million, just what you're seeing on that page there. That's been part of what we've been talking about for 4 or 5 years. We started on an ECTV project, I think, when I was still running Trane commercial 2009. So yes, it takes 4, 5 years to do something like that. Now they come out much faster than that, which is a good sign. But vitality is good. I mean, the vitality for the Trane Applied portfolio were really -- kind of be off the charts in the next 5 years. It won't make any sense. It won't be meaningful. It'll be almost a complete transition of the product portfolio. Unitary, we've been at that and kind of cycling through. So it's a more normalized, kind of 20% to 30% number that we see there. But Applied will be 50% to 100%, probably, over the next, say, 3 to 5 years.

And we have time for one more question today. Our final question comes from the line of Nigel Coe from Morgan Stanley.

So I just wanted to switch to acquisitions. You addressed that question a little bit earlier. But there's obviously been some time since you did an M&A deal and the -- obviously, the bias is still towards buybacks. But are you actively pursuing acquisition opportunities, bolt-on opportunities at this point? And if you are, what do you see in terms of pricing opportunities?

Yes, Nigel, I -- same old broken record with me. I can tell you it's well over 100 things we've looked at and the 5 years since I've been here at this job. And I think it's been 3 years, maybe 5 tops, that we've had a real interest in for various reasons. So it's not as if we haven't been looking and exercising that muscle all of the time. It's just for the longest time, certainly was not as good as the share buyback was, and we've made the right decisions there. So as we look to the future, we're going to continue to hold up that mirror and understand which is more accretive and over what period of time. That's the same old answer on that one.

Okay. And then just switching back quickly to Industrial, the air business. I know we've kind of had a few questions around that already, but just approaching it from a different perspective. You're clearly outperforming with Copco and I'm wondering, you mentioned share gains in air-free, particularly in Europe, but -- sorry oil-free. But if you look at it, smaller systems versus larger systems, do you think that this performance is primarily a mix shift issue or do you sense a gain in share in both smaller and larger systems?

Well, it comes back to basics. It's feet on the street in the right places. It's been a constant drumbeat on the portfolio innovation there unchanged. If that continues, it's the similar story as our applied HVAC business in terms of what that roadmap looks like or the product portfolio going forward. And when we launched those products, we, in fact, launched them with features that are superior to competition, at margins that are superior to what the replacement product was. So it's a double effect when we launch product that we should have margin expansion and growth, and that's kind of what we're seeing there. But there's not -- there's no magic there. It's been -- that group's been hard at it for 5 years like the Trane team has. They had an earlier market recovery than HVAC did, and of course had much more sporty incremental margins for the first 3 or so years of that. And hopefully, that's what we'll see in the HVAC business going forward.

And that concludes our question-and-answer session for today. I would like to turn the conference back for any closing comments.

Thank you, Karen. Thank you, everyone. Joe and I will be around for any follow-up that anyone has. Have a good day.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may now disconnect. Everyone, have a good day.