Alok Maskara: From a units produced, we have internal targets, but we haven’t shared that externally. So I don’t want to go there. I mean, over the long term, we did talk about that we got enough square footage to double the capacity. We think that happens over five years or more. So think of maybe perhaps at max 20% capacity slowly ramped up one line at a time. So I think that’s kind of one way to think about it. But clearly, it will be prudent. We’ll look at market conditions. And in some cases, we can obviously move in balance production between the existing factory and the new factory. So that’s going to be one way to look at it. But we haven’t put in machines in the ground to double the full capacity. We’ve got enough space to do that, but we’ll put those investments as the demand materializes.
Brett Linzey: Okay. Got it. Makes sense. And then just wanted to come back to the forecast on the composition of the new refrigerant products next year. I guess as the old refrigerant supply is reduced, is it reasonable to think the pricing on the legacy units also needs to step up again next year as you’re dealing with less supply?
Michael Quenzer: Yes. As we always do, we’ll come out with a new price increase next year on the 410A system and depending where the cost of that gas goes up, which we expect to go up significantly. It could also have a pretty large increase similar to the 454B product. But we’re monitoring that, and there will be another price increase on that next year for the 35% of the demand.
Alok Maskara: And also keep in mind there will be manufacturing inefficiencies associated with manufacturing the older 410A units because the volume is going to go down and the factory has got to be more complex at higher cost for the 410A that we expect.
Brett Linzey: Got it. Appreciate the color. Great quarter.
Operator: Next question will come from Julian Mitchell with Barclays.
Julian Mitchell: Hi, good morning. And thanks for the effort to improve earnings quality. I think most companies are hellbent ongoing in the other direction. Maybe my first question would be around — the commentary around the sort of second quarter and the first half and so forth. So you’ve got about $1.5 billion sales, I suppose, or thereabout starting for Q2 based on that 50-50 first half split. When we’re thinking about sort of margin profile. Classically, you’ve had sort of 35%, 40% sequential operating leverage in the second quarter just with the fixed cost absorption and so forth. I just wondered if that figure would be any different this year, whether because of the Mexico plant ramp-up or the phasing of, say, those A2L headwinds of 5 million to 10 million that you call out? Maybe just any sort of color around how those items play out from here and the sort of second quarter sequential leverage.
Michael Quenzer: Yes, there will be some additional investments they’re going to start to make in the second quarter that weren’t fully impacted in the first quarter predominantly launching the new commercial factory as well as starting to transition to the new 454B product in HCS. Additionally, we had a bit of a onetime benefit within Q1 for margins for warranty adjustments, so that will also kind of not repeat in the next year or the next quarter. But overall, there will be some cost increases coming into the second and third quarters that weren’t within the first quarter.
Julian Mitchell: Got it. Okay. So still sort of decent leverage, but maybe with some offsets this year specifically.
Michael Quenzer: Correct. Yes, some ramp-up costs that we’re going to need to transition to get the product ready.
Julian Mitchell: Thanks. And then my second question, circling back to the BCS division. Certainly, the tone, I think, from Alok seems a little bit more cautious on that new construction aspect and project delays, and we see that more broadly in things like the ABI readings. Maybe to sort of — if you could put a finer point, Alok, the project delays aspect, is that just an expectation of what could happen later in the year? Maybe any updated thoughts on the education vertical? Is that asset tailwind sort of starts to expire. And I guess the thrust of the question is really, you had 21% revenue growth in that BCS segment in the first quarter, the year is up 10%, is an implied decline at some point just pure conservatism? Or is there anything we’re really seeing on those project delays or education vertical or something like that?
Alok Maskara: Sure. I guess, Julian, the two biggest factors on that is we like to be conservative, and second we had fairly easy comps in Q1 compared to where we were last year. On the demand side, I’ll start by saying we remain manufacturing or production capacity constrained, not demand constrained. So keep that in mind as I answer all the other different points in here. The new construction and the project push to the right is actually happening right now that only impacts 15% to 20% of our sales that was about — 75%, 80% of that is, our sales are all replacement, but we needed to call that out just because it does impact a portion of our sales. But today, it’s not an issue because again, being supply constrained versus demand constraint continues to hold for us.
Education vertical, yes, it had some benefits last year, may have left this year, but it’s really not a material mover for us nor was it last year. So it really doesn’t impact us. The biggest driver of optimism there is the age of units, the units on the rooftop, whether it’s a big box and others, they are way beyond the useful life. Many of them are like 18 years where the useful life is closer to 14 to 16. That’s what drives our optimism about order rates and things going forward. But the delta that you officially asked for at the beginning is easier comps and some conservatism built in because no factory startup goes perfectly, Julian. As you know, factory startups always have some issues here or there. So we just didn’t want to get ahead of ourselves.
Julian Mitchell: That makes sense. Thank you.
Operator: Our next question will come from Joe O’Dea with Wells Fargo. Please go ahead.
Joe O’Dea: Hi, good morning. Thanks for taking my questions. First question is just related to pricing strategy, and I think both on HCS and BCS, you had sort of engaged with consultants and have implemented pricing changes as a result. The question is just related to what inning you’re in, in that, the degree to which that’s complete, the degree to which we see it in the P&L. And as a result, was it a matter of you were pricing below market on a net pricing side of things and maybe you’re above market? Just overall, kind of the outcome of those efforts, sort of where you are pricing relative to what you see pricing in the market being?
Alok Maskara: If it was cricket, I would tell you in the first inning, but since it’s baseball, I have to say we are probably the third or fourth inning of that right now. Where we are is, yes, we were below market price in many of our key accounts where we have signed contracts after the tornado and pre-COVID and we did not have inflation clauses in that. So there was definitely a large portion of our sales where we were and in some cases, still below market their process to get up to the market level. So I think that’s a big part of that. There is a second part of that, which is around giving the local leaders autonomy to an extent to get pricing adjusted, we used to do national pricing and then we realized there is no such thing as national pricing.
Pricing in South is very different than pricing in the North. So we will be able to capture greater pricing excellence just by having more localized pricing and there’s going to be upside on that working through that. The third aspect of pricing is simply around us continuing to capture pricing ahead of inflation because people think inflation has gone away, and it’s not. So as we do price increases and the fact that we lost margin points during the COVID transition and during the tornado, we need to just work with all our channel partners and customers and make sure we get price ahead of inflation, not behind inflation because inflation continues to impact us, whether it’s SG&A or materials or labor, all of that impacts SG&A. So those are the three aspects, I would say we are less than halfway complete, but pleased with progress so far, and especially pleased with some of the price actions we took on key accounts and gotten closer to market, but still below market in some cases.
Joe O’Dea: Got it. And then also just wanted to ask on leverage and when you think about the M&A opportunity set out there, you talked about a long-term target leverage range in the 1x to 1.5x. But if the right opportunity were to present itself, how high are you comfortable taking leverage to pursue that type of opportunity?
Michael Quenzer: If the right opportunity materialize, we’d go up kind of 3%, maybe a little over 3% near term and then quickly want to get back to that 1x to 1.5x after that initial increase to above 3%. But the key is maintaining investment grade ratings. That’s the key.
Joe O’Dea: Got it. Thanks very much.
Operator: Our next question will come from Deane Dray with RBC Capital Markets. Please go ahead.
Deane Dray: Thank you. Good morning, everyone. I appreciate Alok that you’re not going to use any cricket analogies because I would have no idea what you’re talking about. Yes, on the manufacturing line conversion, just give us a sense, is this the clarify, is that the $5 million to $10 million that is in the assumption? And is this in the Mexico facility? And just give us a sense of how disruptive is this to the actual line to change over to the new refrigerants? Are you adding some new components? Is there new testing? Is it a higher pressurization, just what — from a technology standpoint, logistics standpoint, how disruptive might that be?
Alok Maskara: Sure. So the two inefficiencies we called out. One is the Saltillo Mexico start-up inefficiencies. And then we called out $5 million to $10 million of additional inefficiencies on residential for transitioning from 410A to 454B. The change is pretty big. We have to make sure that we are handling appropriately the new refrigerant, which is mildly flammable. So it has a different classification when it comes to DOT regulations, so it requires different piping, different storage, different testing, different test chambers. Though the compressors are new, the size of the product might change in some cases. So it’s a fairly big change, but we’re pretty used to it. We are very ready. This is not starting now. A lot of these changes started last year.
So for example, the new refrigerants line already been in start and the new storage tanks already in the facility. We’re already doing test runs. If we needed to make products today, we would. So the inefficiency costs that we called out would simply be lines shutting down for a few weeks while we make all the changes, test the product and then restart it. That’s kind of the core source of inefficiencies. Most of the investments are already kind of on the floor now.
Deane Dray: That’s real helpful. Thank you. And then the follow-up question for Michael, and I’ll also add my shout out for the quality of earnings. I mean, we had to spend some time this morning to doublecheck that we weren’t missing something. There were no eliminations, and that was the conclusion. I said, oh my gosh, this is as close to gap as any company we follow. So thank you.
Alok Maskara: Chelsey and I were listening to you, Deane, when you told us that at your conference, and we took that as a challenge. So it did start at your conference when you mentioned that to Chelsey and I.
Deane Dray: All right. I appreciate that. And then so that’s — with all this buildup, I’ve got more of a mundane question on free cash flow. We know first quarter is typically a use, but it was less of a use. What are the dynamics there? And you said you’ve got some additional inventory build coming, where does buffer inventory as we distance ourselves from all the supply chain issues? Have you read yourself a buffer inventory entirely? Is that still winding down, but some color there would be helpful. Thanks.
Michael Quenzer: Yes. On the raw material side, yes, our inventories are still higher than we like. They are drifting down better as supply chains are healing. So they are coming down, but we’re going to have to grow them a bit for this Building Climate Solutions transition to ramp up that new factory. But overall raw inventory is getting better. But yes, we will — we’re going to start to grow inventory later this year for the new 410A product and we’re going to start to rebuild and grow some of that in the second half of this year. And then another element that we have within the free cash flow guide is that the CapEx is also going to be a little bit higher in the second half of this year than our normal guide. Normally, we have about $110 million of CapEx. It’s about $175 million.
You can see that there’s going to be more in the second half to complete the ramp-up of the factory and get our transition to the new 454B product ready to go. That’s all helpful. Thank you.
Operator: Our next question will come from Nicole DeBlase with Deutsche Bank. Please go ahead.
Nicole DeBlase: Yes, thanks. Good morning, guys. Thanks for taking my question. I guess first thing is just on the commercial margins, obviously, really, really strong again this quarter. Thinking through all the puts and takes through the rest of the year and how the comp gets a lot harder through from 2Q to 4Q, I guess how much conviction do you guys have that you can continue to expand margins year-on-year through the rest of the year?
Michael Quenzer: Yes. So we continue to do pricing excellence. And we’ve announced up to 8% price increase in Q1. So we’re going to continue to drive price increase, even though it’s going to lap some of the comps, which are going to be a little more challenging. Right now, our guide is volumes kind of flattish to up low single digits in the balance of the year. That normally comes with 30% incremental. So that should help drive our return on sales, operating profit margins up higher. But then working against that as a little bit of the headwinds that we have to ramp that new factory up. So absent of the factory ramp, we still see margins modestly moving up.
Nicole DeBlase: Okay. Got it. That’s helpful. And then we’ve seen copper and aluminum costs rising recently. Can you just refresh us on when that could potentially impact your P&L? Would that be more of like a 2025 concern at this point or something to focus on. Thank you.
Michael Quenzer: Yes. So we see steel increases that are also starting to come up. That’s more immediate. That kind of is on a quarterly lag. The copper and aluminum goes through a hedging process. It’s kind of an 18-month blended hedging process. So we’ll start to see some of that this year, but it will come into next year as well. We’ll continue to monitor that. If it stays elevated, we’ll have to see what type of pricing actions later this year we need to do. But definitely, that would be reflective in the new 454B product, if it continues on pricing and the 410A pricing into next year.
Nicole DeBlase: Got it. Thank you. I’ll pass it on.
Operator: And our next question will come from Steve Tusa with JPMorgan.
Steve Tusa: Hi, good morning. Can you just help me reconcile some of the price and mix dynamics. I mean you guys had put through, I believe, Allied was in January 1 and then the rest of the business maybe in early February. I think they were upwards of like 10% price increases. Price was up 3% in the quarter. So maybe just help me reconcile that? And then what basically gets that to accelerate through the rest of the year. I mean, your price mix was basically 1% for the quarter with negative mix. So maybe just help me reconcile those data points with kind of the mid-single-digit guidance?
