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Lennox International Inc (NYSE:LII)
Q3 2020 Earnings Call
Oct 19, 2020, 9:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Third Quarter Conference Call. [Operator Instructions] As a reminder, this call is being recorded.

I would now like to turn the conference over to Steve Harrison, Vice President of Investor Relations. Please go ahead.

Steve L. Harrison -- Vice President, Investor Relations

Good morning. Thank you for joining us for this review of Lennox International's financial performance for the third 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 requeue 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 for 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.

Before I turn the call over to Todd, I would like to announce the date of our Annual Investment Community Meeting. The event will be held the morning of Wednesday, December 16. The format will be virtual this year. Please mark your calendars; invitations and more details will follow.

Now, let me turn the call over to Chairman and CEO, Todd Bluedorn.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Thanks, Steve. Good morning, everyone, and thank you for joining us. Let me start with a quick overview on the third quarter that continues to be impacted by COVID-19 pandemic, and then discuss our updated 2020 outlook.

For the year, we are raising guidance for revenue, earnings and free cash flow, driven by the continued strength in our Residential business. Overall, for the company, in the third quarter, revenue was up 2% to $1.06 billion, a third quarter record.

GAAP operating income was up 7%, to a third quarter record, $167 million. GAAP EPS from continuing operations was up 16% to a new high for any quarter of $3.42. Total adjusted segment profit was a third quarter record of $177 million, up 1% from the prior quarter that included $16 million of insurance benefit. From an operational perspective, excluding the insurance benefit, total adjusted segment profit was up 11%.

Total adjusted segment margin for the third quarter was 16.7% compared to 17% in the prior year quarter. From an operational perspective, excluding the insurance benefit in the third quarter last year, total adjusted segment margins was up 130 basis points. Adjusted EPS from continuing operations is up 6% to $3.53, a third quarter record.

In our Residential segment in the third quarter, revenue was up 13% to a new high for any quarter of $722 million. Revenue from replacement business was up low double digits. Revenues from new construction was up mid-teens.

Residential segment profit set a new record -- excuse me -- set a new third quarter record at $153 million, up 21%. Segment margin expanded 140 basis points to a third quarter record of 21.2%. On an operational basis, excluding the insurance benefit in the prior year quarter, segment profit rose 38% and segment margin expanded 390 basis points.

Our Residential business benefited from continued strong market conditions and favorable hot weather in July and August. Consumers continued to replace units more than repair, with the equipment growth rate running multiples ahead of the parts growth rate.

September turned significantly cooler, which has continued to-date in October as contractors look forward to winter and furnace season. Strength in the residential market continues and the team is executing well as it continues to take advantage of market opportunities to gain share.

Turning to our Commercial-facing businesses. They continue to be more heavily impacted from the pandemic than residential, as expected. In the Commercial Business segment, revenue and profit were down 18%. Segment margin expanded 10 basis points to 18.7%. National account equipment revenue was down nearly 30% and regional and local revenue was down mid-teens.

Breaking down revenue another way, replacement was down high teens and new construction was down high 20s. On the service side, Lennox National Account Service revenue was down low-double digits. VRF revenue was down low-double digits.

While overall commercial equipment revenue was down 20% in the third quarter, we continue to see signs of relative improvement in the business with commercial equipment backlog currently down mid-teens year-over-year, and order rates reflecting gradual improvement as well.

Our commercial team continues to win new business and position for future growth. Commercial won 11 new national account customers in the third quarter, bringing the year-to-date total to 26.

In addition, our Commercial Group has launched an initiative called Building Better Air, that is focused on improving indoor air quality in commercial spaces. This initiative combines our innovative product line in industry-leading building services to provide comprehensive IAQ solutions to commercial customers. We're helping business and building owners evaluate HVAC systems, recommend a comprehensive indoor air quality solution tailored to the building and identify a maintenance plan to ensure ongoing indoor air quality effectiveness.

Turning to our Refrigeration business segment. Revenue was down 14% at constant currency. North America was down high teens and Europe was down high single digits. Segment profit was down 34% and segment margin contracted 350 basis to 10.4%. Refrigeration profitability was impacted by negative mix with Europe down less than the U.S. in the quarter, as well as factoring inefficiencies due to COVID-19. As in our commercial business, we are seeing signs in Refrigeration, a relative year-over-year improvement from the third quarter, with backlog up and order rates reflecting strong improvement.

A quick update on SG&A cost savings this year. Earlier this year, we enacted a $115 million SG&A savings program. Due to the improved performance of our end markets and our strong operational performance, we have restored compensation and volume-related SG&A costs. Several examples of what I'm talking about are reinstituting pay from the temporary salary reduction, increased sales commissions and paying performance-based compensation. We are now planning for $65 million of SG&A savings this year with 45% coming from discretionary spending, 40% from headcount reduction and the remaining 15% from paying incentives that return in 2021.

To wrap up with our updated guidance on 2020, we are raising revenue, adjusted EPS and free cash flow. Revenue is now expected to be down 5% to 9% for the full year. Adjusted EPS from continuing operations is now expected to be $9.05 to $9.65. Free cash flow is expected to be approximately $425 million.

We continue to face highly uncertain economic conditions in the fourth quarter and remain cautious on the potential impact from the pandemic heading into the winter season. But Lennox has a seasoned team experienced in managing through downturns, continuing to invest and advance the company for the future. We look forward to closing 2020 strong with momentum into 2021.

Now, over to Joe.

Joseph W. Reitmeier -- Executive Vice President and Chief Financial Officer

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 third quarter, revenue from Residential Heating & Cooling was a record $722 million, up 13%. Volume was up 11% and price and mix combined was up 2% and foreign exchange was neutral to revenue.

Residential profit was a third quarter record, $153 million, up 21% as reported over the prior year quarter that included $16 million of insurance benefit. Segment margin was a third quarter record of 21.2%, which was up 140 basis points as reported over the prior year quarter with the insurance benefit.

Segment profit was primarily impacted by higher volume, favorable price, lower material and other product costs, higher factory productivity and lower distribution and freight costs. Partial offsets included the year-over-year difference in insurance benefit, higher selling and incentive expenses and tariffs.

Turning to our Commercial Heating & Cooling business. Commercial revenue was $208 million, down 18%. Volume was down 16%. Price and mix combined was down 2%, and price flat and mix down. Foreign exchange was neutral to revenue. Commercial segment profit was $39 million, down 18%.

Segment margin ticked up 10 basis points to 18.7%. Segment profit was primarily impacted by lower volume, driven by the COVID-19 pandemic and unfavorable mix. Partial offsets included lower material costs, higher factory productivity, lower distribution cost and lower SG&A expense.

In Refrigeration, third quarter revenue was $125 million, down 12%. Volume was down 16%, price and mix combined was up 2% and foreign exchange had a favorable 2% impact on revenue. Refrigeration segment profit was $13 million, down 34%.

Segment margin was 10.4%, down 350 basis points. Segment profit was primarily impacted by lower volume and lower factory efficiency due to the COVID-19 pandemic and unfavorable mix. Partial offsets included favorable price, lower material costs, lower SG&A expense and favorable foreign exchange.

Regarding special items in the third quarter, the company had net after-tax charges totaling $4.4 million that included a $3.6 million loss from natural disasters, net of insurance recoveries, related to an August 2020 high wind damage at the company's manufacturing facility in Iowa; $2.2 million for personal protective equipment and facility deep cleaning expenses incurred due to the COVID-19 pandemic; a net charge of $1.4 million for various other items and a benefit of $2.8 million for excess tax benefits from share-based compensation.

Corporate expenses were $28 million in the third quarter compared to $18 million in the prior year quarter as the company's financial results in the third quarter triggered incentive compensation true ups for performance year-to-date. Overall, SG&A was $152 million, up 6% from the prior year quarter. And for the first nine months, SG&A is down 7%.

In the third quarter, the company generated $440 million of cash from operations compared to $236 million in the prior year quarter. Capital expenditures were $12 million compared to approximately $25 million in the prior year quarter and free cash flow was $428 million in the quarter compared to $211 million in the prior year quarter. The company paid approximately $30 million in dividends in the quarter. Total debt was $1.01 billion at the end of the third quarter and we ended the quarter with a debt-to-EBITDA ratio of 1.8. Cash, cash equivalents and short-term investments were $59 million at the end of September.

Now, before I turn it over to Q&A, I'll review our current market assumptions and guidance points for 2020. For the industry overall, we now expect North American Residential HVAC shipments to be roughly flat this year. We now expect both Commercial unitary shipments and Refrigeration shipments to be down approximately 20% for the industry this year.

Looking at the company's performance year-to-date and outlook for the fourth quarter, we are raising our 2020 revenue guidance from a decline of 10% to 15% to a decline of 5% to 9% for the year. We are raising our guidance for GAAP EPS from continuing operations from a range of $7.31 to $8.11 to a new range of $8.35 to $8.95 for the year. We are raising our guidance for adjusted EPS from continuing operations from a range of $7.90 to $8.70 to a new range of $9.05 to $9.65 for the year.

Looking at the various puts and takes in our financial guidance for 2020 that we are updating, commodities are now expected to be a $25 million benefit for the year compared to prior guidance of a $20 million benefit. We now expect a $25 million benefit from sourcing and engineering-led cost reductions compared to prior guidance of a $20 million benefit.

Residential mix is expected to be a headwind of approximately $10 million for the full year as new construction has outperformed replacement business year-to-date. Our earlier expectations were for new construction to slow and mix to be flat.

We now expect corporate expense of approximately $90 million compared to prior guidance of $75 million, primarily due to higher compensation expense related to the company's performance. We now expect interest and pension expense of approximately $35 million compared to prior guidance of $40 million.

We now expect an effective tax rate for the full year on an adjusted basis of 19% to 20% compared to the prior range of 21% to 22%, due to the timing of certain tax benefits this year; and for 2021, we expect the effective tax rate to be back in the 21% to 22% range.

Capital expenditures are now expected to be $100 million for this year from prior guidance of $120 million on the timing of some spending between 2020 and 2021. And our guidance for free cash flow is now approximately $425 million from the prior guidance of $340 million for the year.

For our guidance points that are remaining the same, price is still expected to be a $25 million benefit for the year. Residential factory productivity is still expected to be a $10 million headwind. We still expect tariffs to be neutral and we continue to expect freight to be a $10 million benefit. The weighted average diluted share count for the full year is still expected to be between 38 million to 39 million shares and our stock repurchase plans remain on hold after repurchasing $100 million of stock in the first quarter for the $400 million that was planned going into the year.

Now, with that, let's go to Q&A.

Questions and Answers:

Operator

[Operator Instructions] And we'll first go to line of Julian Mitchell with Barclays. Please go ahead.

Julian Mitchell -- Barclays -- Analyst

Hi, good morning.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Hey, Julian.

Julian Mitchell -- Barclays -- Analyst

Hi. Maybe just the first question on the topline. The guidance at the midpoint and even the high-end implies sort of step down in Q4. Sequentially, that's much worse than normal. Is that just because of the uncertainty in the environment or is there anything sort of specific that you're calling out?

And may be related to that, just wondered on your latest assessments of the health of the resi market entering next year, I heard you say this year you're looking at a flattish market now. Any thoughts on sort of fundamentals into next year?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

On the first point, it's a combination of both uncertainty in the fourth quarter, but also we had such a strong third quarter, if you're looking at it sequentially year-over-year. I mean, it's a record third quarter for us. Our residential revenue was up 13% driven by hot weather. So, that helped. And so, I think that's part of it.

In terms of looking into 2021, on the markets, we continue to remain bullish on the residential markets. There's lots of moving pieces, but we called -- we're calling for the market to be flat this year. And I think that's an important perspective to remember. I understand that some folks are wondering did demand get pulled in, did something from 2021 get pulled in to the strong third quarter? Two points I'd make. One is, overall year -- the market is going to be flat year-over-year in the middle of the pandemic; second is, just the behavior of residential homeowner, even when there is not a pandemic, no one wants anyone into their house to replace the units unless they have to and there's a catastrophic failure, they replace the unit. And especially in a pandemic, no one wants people coming into their houses and spending two or three days replacing units. So, these are being replaced when they break. And they're not being repaired like they were during the financial crisis. But there has to be approximate cause for them coming in, and that's not pulling forward demand. No one is sort of saying -- let's replace it now rather than next summer. They're replacing it now when it breaks and they have no choice.

And so, we remain confident -- as we talked before -- that we think there's another couple of years of this mid-single-digit growth and for it to be flat. In the middle of the pandemic shows the resiliency of this market. And so, we remain confident in the resi market for 2021.

Julian Mitchell -- Barclays -- Analyst

Thank you. And then my second question just on the margin outlook. Perhaps clarify exactly how much of that $65 million in the savings could reverse or come back into the P&L next year? And what are you thinking for sort of residential operating leverage as you look out, now that the revenue line has returned to growth again?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

I think the way -- the way I think about it is, our new guide on the SG&A take up $65 million. And then when you look at that $65 million, only 15% of it now is paying incentives, because so much came back into the P&L this year. So, the 15% that's paying incentives, that will bounce back next year. So, that's -- whatever the math -- is $7 million, $7.5 million. The balance of it, the 45%, that's discretionary; and 40%, that's headcount -- we control those. And it depends on how the market's performing and investments that we want to make in the business. But our sort of goal of having 30% incremental margins is plus or minus what our target will be for next year.

So, previously our guide was $115 million with a lot more tied to paying incentives. I think that risk is now off the table for next year in terms of it bouncing back on us moving forward.

Julian Mitchell -- Barclays -- Analyst

Great. Thank you.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Thank you.

Operator

Our next question is from Ryan Merkel with William Blair. Please go ahead.

Ryan Merkel -- William Blair -- Analyst

Hey. Good morning, guys.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Good morning, Ryan.

Ryan Merkel -- William Blair -- Analyst

First off, can you just dive -- hey, good morning. Can you just dive into some of the commercial end market performance to give us a little more detail?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

I think we called it somewhat out on the call. We've seen national accounts down more than our local and regional business, and that's what we would have expected, just the way the market behaves that the planned replacement gets deferred as people sort through things. And so, our planned replacement was down mid-20s versus a year ago. But in Q2, it was down over 40%. So, the trend line of planned replacement is going the right direction. And when we look at our order and backlog, the planned replacement as many companies are getting more comfortable in the current environment and some of our large customers are people like Home Depot, Lowe's, Best Buy are doing pretty well, are getting more comfortable spending.

Emergency replacement was down 10%-ish in the quarter, after being down 35% in the second quarter. So again, heading in the right direction. And then new construction is the one that goes the other way, because new construction, things that were in flight, continue to be built. But that new business starts to go down and we saw that down near 30% in third quarter, after only being down mid-teens in second quarter.

And then as we mentioned on the call, the order -- excuse me, the backlog's down mid-teens. And so, the backlogs heading the right direction. But when we think about the full year, we still think the markets will be down 20%. The one silver lining and all of that is the comp gets a lot easier next year. So, when we think about 2021, sort of wish the way the world looks now, we would expect that the commercial market -- commercial unitary market would be up after such a hard hit 2020. And when you look back on history of the Commercial unitary market, whether it's the 9/11 downturn or financial crisis downturn, goes down hard, comes back quickly.

Ryan Merkel -- William Blair -- Analyst

Okay, that's helpful. And then secondly, you mentioned commercial IAQ initiatives. Can you just talk about how big that business is today and then what is your outlook for the coming quarters?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Yes, I mean we tend not to quantify the market. And again, I think you heard in the way I talked about it, we think about it as a facilitator to win the equipment business. And our Build Better Air initiative is leveraging off our historic capabilities and indoor air quality in our relationships with the building owner. And we're an industry leader in indoor air quality in both residential, commercial markets, as we talked about indoor air quality is air purification like filters and UV light, ventilation and circulation and humidity control. Our residential pure air equipment is the best in the industry as noted by Consumer Reports, and then we talked about building better air and our advantages and our opportunities there.

Ryan Merkel -- William Blair -- Analyst

Great. Thanks, Todd.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Okay.

Operator

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

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Hey. Good morning, guys.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

I just want to point out before you ask your question that so many things changed in 2020. I personally feel great comfort that Pittsburgh, Cleveland remains consistent over the decades.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

I knew that was coming.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Okay. Go ahead.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Okay. Can you just talk about your distribution base business versus direct sales in the quarter, and then just talk about how you think inventories are in your channel and at independent, and maybe speak to how the channels thinking about furnace distribution build versus maybe how they managed the cooling side?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

The performance of the businesses were relatively consistent. They were both up plus or minus 13%. So, there wasn't one that outperformed the other. And I read a note, and I thought you raised valid questions around the AHRI numbers versus the HARDI numbers, one being sell out, one being sell-in. And we take great comfort that our Lennox business performed very similar to our allied business, i.e. the sell-through or the sell-out of our Lennox business directly to dealers was up, the 13%, 14% whatever the exact number was. That -- and so that's a good sign for our Lennox business.

Our allied business also did well. I think the direct question -- answer to your question is, inventories are low right now, which is normal coming out of such a hot summer. And then what happens is, there is [Indecipherable] of short memories or however you want to phrase it of dealers, and so they had trouble getting cooling product in summer, which many did because our competitors had trouble delivering, then they want to make sure their barns are full with furnaces. And so, we see that right now as people are loading up on parts.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Okay. And then just on Refrigeration, I think you said backlog was up, maybe what's differentiated in the order trend there? And then I think you've mentioned COVID disruption there. What's unique about the facilities there versus the other businesses?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Yes, the -- we got hit both in our European business and in our shift in Georgia business. If you look at shift in Georgia on a map, it was in one of the hardest hit areas for COVID in the country. And so, that had some impact on our business, and so absenteeism and then actually having the factories shut down for a bit in both locations impacted our productivity.

When you look at the backlog of Commercial -- as you know, we're more exposed to retail there than we are in Refrigeration. And that's been a softer spot. And then also in Refrigeration, cold storage is one of our largest verticals and that's been relatively strong, given that people are building out cold chain to support different consumer buying habits of buying food at home and also maybe a bit are preparing for the vaccine. And so, we've seen strength in cold storage and that's helped us.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Okay. Thanks for the color.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Thanks.

Operator

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

Joe Ritchie -- Goldman Sachs -- Analyst

Thanks. Good morning, everyone.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Hey, good morning.

Joe Ritchie -- Goldman Sachs -- Analyst

Hey, Todd, maybe just commenting a little bit on the resi HVAC monthly trends. Obviously, you guys had told us that July was up. I'm just curious how the rest of the quarter went? And then as you're switching over to furnace, I'm just curious whether you think there are any issues that may occur just given how strong HVAC has been just from a manufacturing perspective? I'm just wondering if there is any kind of like pig in the python type problem as you try to deliver on furnace sales?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Yes, the trend line during the months July and August were up mid-teens, as I talked about on the second quarter earnings call, at least on July. And then September was up significantly, but up more low-double digits, high single-digits as you sort of got away from hot summer selling season.

We're positioned as well or better than anyone in the industry to meet both cooling demand and furnace demand. So, we think we're in good shape. I think some of our competitors may have issues; and again, I think it gets more pronounced as if you have independent distributors trying to get large orders from all at once, and maybe our competitors are seeing some of that. But we think we're in good position as well -- as well or better than anyone in the industry to meet the upcoming furnace season.

Joe Ritchie -- Goldman Sachs -- Analyst

Okay, great. And my one follow-on is, as you think about 2021 -- and I know it's probably a little too early, but I'm just trying to think about how to think about the price cost dynamics in resi, copper is up a lot, but you mentioned getting good price mix this quarter on the resi HVAC side. Any comments on just the dynamics heading into 2021, just given the increase we've seen in commodity costs?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Yes, I'll broaden the question, just sort of talk a little bit about 2021 more broadly. Obviously, lots of moving pieces. There is always uncertainty in October when you think about following year, but maybe as much now as ever. And I talk a little bit about the end markets earlier, I'll repeat that. We walk out or almost out of 2020 with a clear understanding of the resiliency of the residential market. And again, it's demand that's being caused by the home failing and we model all out. We think there's another couple of years of that. So, we think mid-single-digits next year for residential and new construction remains strong.

For Commercial and Refrigeration, as I talked earlier, more uncertainty there. But after being down 25% -- 20% this year, we'd expect some rebound in 2021. Directly to your question is, we do expect some commodity headwind for next year, but I would also just mention, we've always historically said commodities that matter most to us are steel, copper, aluminum, in that order.

With all the work we've done on moving to aluminum and our heat exchangers across our business, it's now steel, aluminum and copper, that's most important to us; and so while copper still matters, it matters significantly less than it did four or five years ago; and aluminum, I think it behaved more nicely, if you will, and I sound like a President with that terminology, but it has behaved better.

And so, we expect some commodity headwinds. We expect some freight headwind at the current point in time, although that still has to be shaping up. Then, as we talked about, we expect a little bit of compensation bounce back, given the take-up or reduction this year. But as always, we are going to be announcing a price increase here shortly, and we expect to get price next year, just like we do every year.

We're going to benefit from sourcing and engineering cost reductions. We talked about raising that number from $20 million to $25 million this year. And so, that's order of magnitude that we've done for the last decade, $20 million to $30 million depending on the year.

Factory productivity, after not really having much of any factory productivity initiative, as well as the disruptions because of COVID, we'll get back on track there. And then, as always, our target of 0.5 point of market share gain.

So, I know I haven't quantified a lot of those, but it is to send a signal that we think the set up for next year will be not dissimilar to set up of prior years where we have markets up, share gain priced to offset commodities and then continued productivity in material costs and factory productivity.

Joe Ritchie -- Goldman Sachs -- Analyst

Thanks. Appreciate the color.

Operator

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

John Walsh -- Credit Suisse -- Analyst

Hi, good morning.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Good morning.

John Walsh -- Credit Suisse -- Analyst

Maybe just a finer question on that commodity discussion we just had there. You took commodities and the sourcing combined up $10 million relative to where we were in Q3. Just how much of that falls through in Q4 versus how much has been realized kind of the year to date?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

I'm not sure, to be honest with you, John. Maybe we can sort of guide that. I think the commodities, I think people are scrambling diligently to sort of find. I think the commodities tamper down as we go through the year where the material cost reduction starts -- continues to increase as we go through the year. So, if I had to guess, I would say commodities are around $20 million, $22 million year-to-date and then MCR, I think the raise is just confidence that we'll continue to execute for the balance of the year.

John Walsh -- Credit Suisse -- Analyst

Great. Thank you for that. And then just I guess maybe you talked a little bit about 2021, just kind of two questions on my mind. I mean, you just talked about your normal kind of market share gains. But as I understand it, one of your competitors, right, had a factory disruption. And so, they might have not been able to fulfill orders and that arguably comes back online next year. So, does that make it harder to get that kind of normal market share gain that Lennox has been getting?

And then maybe just on this replacement pull forward question, I guess it depends on how you think we look from a work-from-home benefit next year. But when it -- because we were sheltering, we'd see more breakage this summer that needed replacement, arguably, that pulled from one '21 into '22 or is that just not the right way to think about it? Would just like to get your perspective there.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

I'll answer the second question first. And not just you, John, I've heard other talk about that.

John Walsh -- Credit Suisse -- Analyst

Yes.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

I don't think that's how it works. And what I mean by that is, I don't think people set their thermostats in 85 when they go to work, and then when they come home they set it to 68. But I think the majority of people don't even set their thermostats on a time or just sort of remains constant over time. And then I think people raise it may be to 78, 80 when they're gone and then 75 when they get back.

So, I don't -- and in terms of usage, that doesn't drive a spike up where units all of a sudden have huge acceleration of use and breakage. So, I'd just step back and say the market is flat year-over-year in 2020. That doesn't show pull forward to me. It's just flat in hot summer. So, market is flat in hot summer. That doesn't show pull forward to me. That's just people are hesitant to spend money unless they had to. But when a unit breaks, they replace the unit rather than repair that. I don't think there is -- I don't think anything's pull forward because people were at home.

Remind me what the first question was.

John Walsh -- Credit Suisse -- Analyst

Oh, just on the ability to kind of get your normal market share gains. I mean, I know it's --

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

[Speech Overlap]. Yes. One, give me personal privilege to just sort of observe that. When we lost because of tornado, everyone assumed we'd never get it back; and now that we've taken it from others, there is an assumption that maybe we won't build or hang on to it. I think a couple of things. I think having been on the other end of it, we were cognizant in a constrained supply environment to supply the dealers who we thought we had the best chance in keeping the business to. So, we weren't selling arms to anybody. We were selling arms or units to those dealers we thought we had -- we were already sort of into conversations with and converting over, and those are the ones we sold to.

So, we made -- we're not going to hang on all that we've gained, but we're going to hang on to a lot of it, a whole lot of it; and then we're also on the path to get more shares. So, I remain confident that we'll get -- we're gaining significant share this year and I'm confident we'll gain share.

John Walsh -- Credit Suisse -- Analyst

Great. Thank you. That's really helpful color.

Operator

And next from the line of Deepa Raghavan with Wells Fargo Securities. Please go ahead.

Deepa Raghavan -- Wells Fargo Securities -- Analyst

Hi. Good morning, all.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Good morning.

Deepa Raghavan -- Wells Fargo Securities -- Analyst

Todd, can you provide your thoughts on when you think you can resume share buybacks. It looks like you're starting to loosen up on some of the variable costs and getting comfortable given your strong cash outlook. So, will it be normal for us to assume buybacks return in 2021?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Yes, I'll be more direct -- put it in your model. We are not going to start it up here in the fourth quarter given some of the uncertainty. But when we give the December guide for 2021, we'll be back to a more normal stock repurchase program for 2021.

Deepa Raghavan -- Wells Fargo Securities -- Analyst

Great, thanks. Can you -- how do we think about normal-volume driven leverage in 2021? I mean, you have -- you're going to have all these cost in and outs, rollbacks, more thinks like more headwinds. I don't know price gets that much more incrementally better. So, should I think about your volume-driven leverage should be slightly below trend or should all those dynamics not impact just given that you probably should be able to price for them or take cost elsewhere?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Our variable gross margin is around 40%. So, volume drops through it sort of normal 40% either direction; and then obviously in a year where we're spending SG&A and doing other things, then the incrementals goes down. And so, that's how we end up with the 30% incremental that we're making investments in the business, building out distribution, driving productivity but sort of normal volume leverage is about 40%.

Deepa Raghavan -- Wells Fargo Securities -- Analyst

Got it. Thank you very much, Todd.

Operator

And next we'll go to Gautam Khanna with Cowen. Please go ahead.

Gautam Khanna -- Cowen -- Analyst

Hey, thanks, good morning, and great results.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Good morning, Gautam.

Gautam Khanna -- Cowen -- Analyst

I had a couple of questions. First, I was wondering if you could maybe frame the magnitude of the pricing opportunity for resi. You mentioned you're going to announce a price increase. Just should '21 be a better net realization year than normal? Any framework for that?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Yes, I mean I'm going with hope what we'll announce will be what we always announce publicly for the second quarter what the final number is going to be. So, we'll announce price. But, yes, I do think there is -- one, we expect the market to be up after having been constrained year before. That sort of leads you to believe you can get price in the marketplace as we spoke about when we're having challenge meeting demand as we did -- as the whole industry did in 2020, wasn't really the right time to raise price dynamically the middle of a season.

When we go into next year, we'll be looking to raise price and for a couple of reasons. One, we talked about commodities. COVID has added cost to our cost structure. You talked a little bit about what happened in our refrigeration margins because of it. Quite frankly, it's impacting the entire business, both on the SG&A side, we think we have to do to manage suppliers and manage our own business, absenteeism in our factories, and then we think rates are going to be up. So, those are all reasons on why we're going to need to pass price on and I think our -- in fact, I know our competitors see the same for us.

Gautam Khanna -- Cowen -- Analyst

Thanks. That makes sense. And also, could you just expound upon the IAQ opportunity, level of engagement with customers? Does it drive like a much bigger retrofit cycle? Anything you can talk about that?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Yes, I mean I -- I may be -- I don't know what the right phrase is, maybe more clear-eyed on IAQ. I don't think it's billions and billions and billions of dollars of opportunity, at least in unitary, where we play, and in residential. I think if you're showing a $5,000 residential units a year, your indoor air quality component is $400 or $500. On commercial, it's maybe less of a percentage.

So, I don't think it drives the overall ticket. I think what happens is you have to have knowledge and expertise in it for those customers who want it, and you want to steer customers who wanted to be able to handle their questions. And so, commercial customers have Build Better Air. Sit down with them, talk about what we have, and we have everything; and then put it in place and then use our NAF and National Account Service to measure and monitor the compliance. In our Residential business, it's our PureAir S, which has both passive filters and active UV lights that allows us to clean air, and then also it's digitized, so those part of our iComfort controller. You can measure and monitor what's going on.

And so, I think it's being an expert in the area that allows you to win the jobs and convert dealers, and that's where we're focused on.

Gautam Khanna -- Cowen -- Analyst

Thank you very much, guys.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Thanks.

Operator

And next we'll go to Nicole DeBlase with Deutsche Bank. Please go ahead.

Nicole DeBlase -- Deutsche Bank -- Analyst

Yes, thanks. Good morning, guys.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Good morning, Nicole.

Nicole DeBlase -- Deutsche Bank -- Analyst

We covered a lot of ground here. But I guess on the free cash flow guidance, it doesn't really embed a whole lot of free cash flow in the four quarter. I'm getting to something a little bit more than $30 million. So, just thoughts on -- I'm guessing that working capital is kind of the biggest swing factor there. So, any thoughts that you have about what we should expect for 4Q?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

That's the answer. I know the sequence of the quarter is different this year. By the way, they're going to be different next year, and we'll talk about that in December. But we're typically at this point in time driving down production levels and burning off inventory. But given the hot summer selling season, and given that we expect the markets to be down, while we saw summer selling season was a burn off of inventory, burn off of receivables, payables and then what we see in Q4 is on a year-over-year basis the inflation of inventory and working capital. And so, that's why you see -- we typically have the big cash quarter, fourth quarter. This year, we had the big cash quarter, third quarter.

Nicole DeBlase -- Deutsche Bank -- Analyst

Okay. Totally makes sense. Got it. And then just one more on Refrigeration. So, I think you characterized -- you quantified a bit of what's going on with order and backlog within Commercial. Could you just provide some detail around what you're seeing in Refrigeration, Todd?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Yes, I mean, our backlog is up year-over-year, right now where we stand, and the order rates on a three, six, nine-week basis are all up in Refrigeration. So, the trend lines are good. I think it's both.

In our North America business, there is distribution business where we sell through -- about half of its distribution business we sell through large refrigeration wholesalers, and that has bounced back from being down significantly in second quarter. And then the other business is project business or our cold storage. And that, as I mentioned earlier, has been relatively strong.

Our Europe business has been strong. But we're a little, obviously, a little overconcerned about COVID and lockdowns in France and Spain and what the trendline is there. But again, on -- for the last three or four months, our business in Europe are at the order rates and also trending the right direction.

Nicole DeBlase -- Deutsche Bank -- Analyst

And have you actually seen any slowdown in Europe or is that just reading the headlines and being concerned about what could materialize?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

We're starting to see things slow down.

Nicole DeBlase -- Deutsche Bank -- Analyst

Got it. Okay, thanks. I'll pass it on.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Thanks.

Operator

And we'll go to Nigel Coe with Wolfe Research. Please go ahead.

Nigel Coe -- Wolfe Research -- Analyst

Thanks. Good morning, everyone. Obviously, residential margins were exceptionally strong ex the prior year insurance benefit. I'm just curious, can you -- you think if volumes remain sort of high-single digit, low-double digits in the 4Q and maybe even '21, you can maintain above 40% incremental margins? And then within your commentary on the margins, I think you mentioned sourcing commodities actually now more the benefit than you expected last quarter. Is that mainly volume-related?

And then, I'm just surprised that freight isn't turning into a -- it's more of a headwind. Can you just maybe just address what you're seeing on freight utilization?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Freight remains tailwind this year, and part of that we were aggressive on -- we're managing freight like we've managed over the last year or two, we've invested in Freight management like we did in NCR 15 years ago. And so, we have a pretty sophisticated team. We now have the tools to measure it. And so, I think part of it's just productivity on our side, regardless of what's happening with the overall rate, and we expect to be a tailwind this year and a bit of a headwind next year.

In terms of residential margins, I think you sort of see a peak out in the current environment, where we had volume, we had done aggressive SG&A cost reduction and we had invested in stores because of the tornado. I think on an ongoing basis, since residentials 60% of our business, we talk about 30% incrementals. I think that's plus or minus what you should think about residential. I don't think it remains 40%, because we're investing in SG&A. We're investing in stores and we'll start to back up in 2021. And so, we'll have the investment headwind, if you will, that feeds the engine on an ongoing basis.

And then was there another question? Did I miss anything?

Nigel Coe -- Wolfe Research -- Analyst

I think actually you covered that one. Just wanted to touch back on the buyback comments. You mentioned '21 would be obviously a more normal year on buybacks. I think normal for you, Todd, would be 350 to 400 would be sort of the run rate. Is there any catch-up from the '20 air pocket on buybacks, or are we back to the $350 million, $400 million?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

I think the way to think about it is and you can run the model on your own, right, is we don't want debt-to-EBITDA to go above 2, that's sort of our peg point. And so, we will invest in the business with capex, we'll do acquisitions, but we don't. And then what's left, we'll pay dividends and share buyback. And so, I think you model all of that and I think we start to peg what we do. I don't think this year we'll do $600 million or $700 million, if that's a direct question. But there maybe we do a little bit more, but it's all going to come down to that formula.

Nigel Coe -- Wolfe Research -- Analyst

Okay, thanks a lot.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Thanks.

Operator

Our final question will be from the line of Steve Tusa with JPMorgan. Please go ahead.

Steve Tusa -- JPMorgan -- Analyst

Hey. How is it going?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Hey, Steve. Good.

Steve Tusa -- JPMorgan -- Analyst

On tax rate, what's kind of the go forward you guys -- is this kind of 19% to 20% the right number, and have you guys kind of evaluated? Does that kind of revert if there is -- I know you like to talk politics, if that -- if there is a blue wave or buy-in, does that revert to a certain level, maybe not back to where it was, but what's kind of the long-term view on the tax rate --?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

As Joe mentioned in the script, we -- for '21, we think tax rate is going to be 20% to 21%, so it goes back to more normal rate as we got it this year. We had some discrete items this year that allowed us to take it down. But 20%, 21% is what we're seeing next year. And then beyond that, who knows. But we'll react whatever is done and we'll adjust accordingly.

Steve Tusa -- JPMorgan -- Analyst

Just going back to this kind of resi-cycle discussion. So are you saying this year was kind of ended up being a normal year despite the pandemic, so there wasn't really a push or pull in and out of this year? And I know you guys had had that housing echo boom chart out there, we're kind of a couple of years into that chart. So, are we still thinking that that's the swing factor in this cycle? I mean, housing peaked in five, 16-year useful life. I mean, is that still the way to think about it that '21 from an echo boom perspective is kind of a peak year or is there something that happened this year that kind of changes that profile?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

I think I'd answer 2020, this year is we had a warm summer, and we also had a pandemic. And I think broadly they offset each other and we have flat market. So, I think if we didn't have a pandemic, the market would have been up more. And I think if we hadn't had a hot summer, the market would have been down. And I think -- we think the right comment is, when you look at the AHRI numbers, I'm doing this from memory, but through August it's down about 3%. We think from a year-to-date basis, that's close to flat when it all shakes out.

Steve Tusa -- JPMorgan -- Analyst

Right.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

So, that's our call. In terms of the market going forward, yes, I think we've been pretty consistent. I know we disagree, Steve, I know that. But we -- when we model it and look at it, we still think we have another couple of years a mid single-digit growth. Everything else maybe more. And if it's a hot summer, maybe better; cold summer will do worst.

Steve Tusa -- JPMorgan -- Analyst

Is that echo boom analysis still in play or is there something else driving it?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

No, it's still in play.

Steve Tusa -- JPMorgan -- Analyst

Okay. And then one last --

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

[Speech Overlap] I don't think the pandemic pulled anything forward. If people are sort of saying there is another couple of years but it all got pulled in this year, I'd say -- no way, because it's flat market. Hot summer doesn't make any sense.

Steve Tusa -- JPMorgan -- Analyst

Right. Absolutely. And then just one last one on free cash flow. You've bounced around a bit here in the last couple of years, what is kind of the normalized conversion rate for you guys? And again, just to reaffirm, that's on a GAAP basis when you talk about conversion, right?

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

It is. I read a note, it said 90%. I think if you look at a longer horizon, it's closer to a 100%, and that's our number, 100%. And this year we're having strong cash flow and that's obviously because -- one, we performed EBIT-wise, but obviously if you deflate working capital, you generate cash net. So, we did. And so, in the years where we were inflated working capital, we have more headwind; in years where we were building Mexico, we have headwind and then tornado, so lots of moving pieces. But over a longer perspective, it's a business that will generate 100% of net income.

Steve Tusa -- JPMorgan -- Analyst

Yes, I think Arnold [Phonetic] was talking about adjusted, to be clear, so that would be more close to 100% if it's on a GAAP basis, so just to be clear on that one. All right. Cool. Thanks a lot, guys. I appreciate it.

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Thanks. Thanks, everyone. To wrap up, the residential market remained strong entering the fourth quarter and Commercial and Refrigeration markets continued to improve. The Lennox team is executing well and taking advantage of market opportunities and share gains. We look forward to closing 2020 strong with momentum into 2021. And again, thanks everyone for joining us today.

Operator

[Operator Closing Remarks]

Duration: 54 minutes

Call participants:

Steve L. Harrison -- Vice President, Investor Relations

Todd M Bluedorn -- Chairman of the Board and Chief Executive Officer

Joseph W. Reitmeier -- Executive Vice President and Chief Financial Officer

Julian Mitchell -- Barclays -- Analyst

Ryan Merkel -- William Blair -- Analyst

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Joe Ritchie -- Goldman Sachs -- Analyst

John Walsh -- Credit Suisse -- Analyst

Deepa Raghavan -- Wells Fargo Securities -- Analyst

Gautam Khanna -- Cowen -- Analyst

Nicole DeBlase -- Deutsche Bank -- Analyst

Nigel Coe -- Wolfe Research -- Analyst

Steve Tusa -- JPMorgan -- Analyst

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