Lennox International Inc. (LII) Earnings Call Transcript & Summary

Got it. So this also then raises the potential for a much better incremental margin compare as we go into 2021.

Right.

Because this year, I think it's going to be 20-ish percent.

Right.

Right? First half are going to be soft.

Yes. We're making some investments. We're making about $15 million of investment in distribution. And that includes, but it's not exclusively a distribution in the residential business. And then we continue to make investments in R&D and IT. We'll drive $25 million out of our products with sourcing- and engineering-led cost reduction efforts. We're going to go out and get 1% price. We got 2% in 2019, largely because of commodity headwinds, but with commodities at our back, we still feel that we can go out and get 1% yield of price. And then we'll continue to leverage SG&A and manage investments going forward.

Yes. So speaking to that, and I know you haven't given tremendous granularity in the long-term guide. But in 2021, shouldn't we think of a much higher than 30%, just given just the mathematics of...

I'm not going to earn this up for 2021 yet.

No, I understand.

I want to entertain Quarter 2 in 2020. But there's nothing recurring. So I think you look over our long-range plan, which is typically 3 years. Our expectation would be over that 3-year horizon, we're going to average 30% incrementals. And as you know, as here in 2020, it's going to be closer to 20%. So that would imply that '21 and '22 are going to be higher.

Got it. No, that makes a lot of sense. One of the questions we get a lot is where we are in the resi replacement cycle, given housing peaked in 2005, and the average life of a unit, are we late in the cycle? Are we over the question? What's your view on that? And how do you take comfort with that?

Yes. We still think that there's 2 to 3 years of a multiple of GDP demand for residential replacement resulting from housing echo. And we think, once again, 2 to 3 years. And now that we've got more sophisticated systems, and we have 10-year warranties. We've got Lennox with more data than we ever have. So it's a situation where we can do more analysis around that. And I think if you would have asked us 5 or 6 years ago, the life of a piece of equipment is probably, we would say, 12 years, but there wasn't a piece of evidence to support that. And now we've got some facts to support that. And when you sort of layer on top of one another, the bell-shaped curves, it's sort of indicates we have 2 to 3 more years of multiple GDP demand on residential replacement.

And that's because it's 15-plus years now, like...

What we think it's approximately 15 years. It depends on where you're at. So if you're up north, your commissions probably going to last a little longer. If you're in Texas or Arizona, it's probably going to be less than 15 years.

Understood. Okay, that's helpful. And then when we think about your market -- Lennox's market assumptions on resi, this aggregates to kind of low to mid-single-digit growth on the resi side. Is that fair?

Yes. Yes, the way that we've talked about it is mid-single-digit growth for the residential market. If you take that 50 basis points of share gain that I mentioned, that adds about another 2 to 3 points. And then another point for price to get us to the high single digits quick on the residential side, and that doesn't consider the fact that we had a cooler summer and a warmer winter in 2019. Still are, by the way. Heat degree days are down 12% year-over-year. So it's making a little bit more challenging here in the first quarter. But we think if all that sort of swings our way, it's going to be a pretty good year.

Okay. And one of the things I just want to understand is with the PartsPlus rollout, presumably, that contributes to the share gain that you're talking about. Do you have any sense for how much of the 0.5 point of share is accounted for just from natural?

Yes, I would say, at least a 0.25 point is attributed to the rollout of our Lennox stores.

Okay. And that's going to continue, obviously, for the next couple of years and pause?

Yes.

Okay. Another thing I was curious about on the resi side. Todd has talked a lot about how the conglomerate structure at Carrier and some of the other names has kind of encumbered them in terms of product development, product refresh. And you guys have been a share winner for over a decade on a relative basis. We just heard of Carrier, on Monday, talk about a total product refresh and what have you. I'm just curious, does this market get incrementally more competitive from your view? Like when you look over the 3-year period, it would sound as though that's the case, but...

Yes, I think, they're going to be more focused, but I'm not necessarily sure that it intensifies the competitiveness. I mean, it's already pretty darn competitive. So -- and they were running the business, and they were pretty good at it for the last 50 years when they're part of United Technologies. So I'm not sure anything significantly changes. What I think may be opportunistic is there's a lot of initiatives around cost reduction. And then literally just getting their ways on their own. So I think there may be an opportunity for others in the market as they focus on more inward initiatives. And we'll see how it goes. Once again, they're a good company. So we'll see. I'm interested in how they do, obviously. But it will be a situation where I think we'll have some lights shined on things that when they were parting many technologies weren't visible.

Got it. Can we shift to commercial?

Right.

To commercial unitary? You guys have guided kind of the market to be relatively flat, if you recall, this year? What are your longer-term expectations in that market? And why is it flat this year? What's...

Yes, I think it's a situation where residential new construction, particularly where we compete, is heavily retail-oriented. And that's going to be down. We think the replacement market will be up, net-net. It will be a flat market. Similar to the residential side of the house, we're targeting 50 basis points of share gain. That gives us another couple of points of growth. A point of price. So that gets us to 2%, 3% growth in that business. But we continue to win share, both on the equipment and service side of that business. And we still think we have a long way to go on our emergency replacement initiative where we're undersized relative to the share that we have in new construction and in planned replacement. So there's a lot of opportunity in that business for us to grow organically.

Speaking of which, how large is the emergency replacement business now relative to the overall segment?

That's typically -- well, for us, it's probably about 10% -- we have about 10% market share. And I'm trying to do the math in my head quickly. It's probably less than 20% of the business. Yes.

Okay. And does that typically have -- is that mix accretive? Or is that mix dilutive?

It's -- once again, we design the products for low cost. And one of the prerequisites of that market or for that type of customer is you need to have a low first cost, you need to have distribution where you can get in the hands of the dealer or contractor within a 24-hour window, made investments in distribution, and we continue to revisit the cost side of the equation. So the margins aren't all that distorted relative to the overall margins of the business.

Okay. And one of the things, I remember years ago, you talked about a curve that sort of match the footprint of the Carrier product group. We've heard JCI kind of launched a similar -- is that market getting more competitive?

It's always been competitive and that's emergency replacement market. And once again, I think, one of the advantages that we had is we historically didn't have that product. So we weren't an alternative for dealers or contractors. Contractors like to have options, and we gave them options. And they like the Lennox product and some of the dealers, unfortunately, that we had done business with on other things, planned replacement and new construction, we simply just couldn't support them in emergency replacement, now we can. So we had some captive business right there. And then we had some additional business where we had to go out and recruit new dealers and let them know that we have the Lennox product available. Carrier had the largest installed footprint. They had about 30% market share at that time. And we have an alternative for them when it comes to replacing that even on the roof.

Got it. Okay. Looking out beyond 2020 in the unitary market, sort of, what are your high level observations? Do you think this is still kind of a flattish market? Or...

Yes, I think, once again, it's the dynamic between replacement and new construction. So new construction, particularly in retail, I think, will continue to be flat to down. But we still think there's opportunity in planned replacement because the economics are very attractive for the sophisticated customers that we serve on the commercial side of the business. And they behave differently than the residential customers. Residential customers will replace on catastrophic failure, where a lot of retailers or commercial-facing customers are going to replace when the economics are advantageous for them to deploy the capital to achieve those returns. And we continue to make investments in efficiency, add capabilities around controls, indoor air quality, the humidification, things like that, that make it very attractive for us. So we've got a 15-year asset that pays back in 3 years or less. And they're looking -- continually looking for ways to drive down their operating costs and investing in some of our rooftops, helps them achieve that.

Are there any mandates? There's the 2023 DOE mandate. Could you talk a little bit about how that might...

Yes, I think -- yes, I think, once again, we're prepared for that. So it's not a situation where it's going to distort demand or have an adverse impact on any demand patterns that we think prospectively. We went through it already on the residential side, where minimum efficiency went from 13 to 14 SEER. So it's a minor step. And I think one that will almost do rather stealthy.

By the way, at the time, I remember the cost to manufacture of 14 SEER was higher.

It's about 10% more.

Correct. And how did the pricing evolve over that -- from the start of that mandate till now?

What we expected, and you always have this with the minimum efficiency, that's where more of those issues on price take place in the marketplace. But our focus wasn't necessarily on that because the market was going to dictate the price, quite frankly. It was a situation where we just aggressively attack the cost side of the equation. And we're able to preserve margins by holding price where we could, but also harvesting the investment that we made in reducing costs.

Right. Okay. And so you guys have had quite a bit of success on the national account side of the house. What does the pipeline look like there? Like you mentioned, these folks typically think of it as a return on investment decision, not catastrophic failure driven. What are you seeing there? And what's...

They're not building a lot of new stores, but the ones they have, they're maintaining or investing in for the reasons that I explained earlier. And we go to market a little differently than some of our competitors. We have a dedicated sales force that calls on contractors and one exclusively focused on national account customers. And with some customers, we've designed specific products for them. And I think there are certain capabilities within Lennox that they value, the configure to order product, I think we all have, but the flexibility and the reliability that Lennox delivers, I think, helps us gain continued momentum in the national account arena with commercial customers. And once again, it's been situations to where we lost customers and simply we lose them because of price but they come back for other reasons, too. And once again, we hold our ground sometimes as a result of that. But once again, it's a very attractive area of the business for us, a long courtship with those customers. It takes a while to, first of all, gain their confidence and steer them towards Lennox. And then it may take a little longer before you begin to see orders, but once you do, it's a great relationship. And like I said, we've got a great team that supports our national account customers.

Any way to disaggregate the 0.5 point of share you're expecting in commercial from national accounts versus other? Or is it equally weighted?

Yes. Once again, I think, our momentum in emergency replacement remains to be a significant catalyst for us in that business. And then we're always on the share gain train when it comes to national account customers and adding new accounts and adding new geographies.

Okay. That makes sense. VRF. Where do we stand there? How big is that business? How quickly is it growing? Can you talk about any initiatives there?

Yes, it's a small part of the U.S. market. It's growing high single digits, I believe, still. Yes, maybe a little bit more than that and even low double digits. But it's a situation where we've always got a great partner, Midea. We've designed the product to our specifications from the North American market. We've got a great team that sells that. And some of our new national account customers, the VRF product has been an opportunity for us to get into different verticals from where we historically didn't play, and that would be in certain hospitality applications, schools are a big consumer of VRF product, combined, where we can package both rooftop and VRF product, medical facilities and things like that where we can use the VRF product to approach on some of the smaller applied applications and displace what would traditionally be an applied system.

Right. And I was going to ask, I mean, is there any appetite to actually take a bigger look at the applied market to kind of...

Yes. We have an applied business in Europe. So we understand it. But it's a completely different business, everything from, obviously, design of the product, channels to market, manufacturing capabilities, different ways to go to market, where the product needs to be specified or engineered and tailored to a specific system. And there are some very well entrenched competitors. So we, quite frankly, just have a desire to maintain our relationship and our focus on the unitary side, and then we'll dip our toe in the water of applied with our VRF application when the opportunity presents it.

Got it. Right. Makes sense. On the refrigeration side, we haven't talked about that yet. Talk about end market demand, what are the drivers there? What's sort of the longer-term outlook, and that's...

Yes, the traditional grocery store format has been one that's been challenged or I mean almost depressed for a while now. So we look for other areas, where our refrigeration systems, where we're an industry leader, here in North America, can deploy that technology. And as there's become more and more of an appetite for cold storage capabilities farther back in the supply chain that, that's one avenue for us. We've also developed an application where we've reengineered some of our existing products for more industrial cooling capabilities, once again, cold storage -- along the lines of a cold storage application, but just a little bit different twist to our traditional refrigeration product. And then industrial cooling, which, in Germany, we have a business that makes a cooling system for large industrial processes, very good business in Germany, very attractive margins. We've made some investments in the U.S. to bring that here and partner with some folks. So we're going to see how that goes. But there's still some attractive verticals on the refrigeration side. And we've scaled the business back. So you mentioned earlier a lot, some of the divestitures we made, and we've made that such that we can focus really on North America and in Europe with our refrigeration business, and still think there's opportunity for us to grow the business and expand margins.

Now within both commercial and refrigeration over the past 2 years, we've cited factory productivity challenges at times. Can you elaborate on what those were and where you are?

Yes, some of them are self-inflicted, to be quite honest with you. So in situations where we just drop the ball on the factory floor. We fixed that. With tight labor markets, it became more and more challenging as we had higher turnover in the factories, and you lose folks, you have to retrain them. That really is a drag on productivity just by virtue of that. So we've had to revisit some of our pay scales in some of the factories. And then we would always have a proportion of our factory workforce that was temporary in nature, where we would use them for peak seasons and then cut them loose, but then as the labor markets tighten, it became more and more difficult to even find the temporary folks. So we expanded it such that we have more of a permanent labor force, enables us to be more effective with some of the productivity initiatives. And we have some productivity gains in our 2020 guide.

Got it. So those are basically, at this point, behind you? Those issues?

I hope so.

Okay. Yes.

Yes, some of them we knew because we started seeing some of the benefits as we exited 2019. Some are still in front of us, but we've got a close eye and lens on measuring and monitoring our progress on those productivity initiatives.

I just want to get back to the more immediate stuff. You did talk about heating degree days to being down in the quarter. Obviously, Q1 is not the most important quarter for the year. But can you talk about kind of where things stand in Q1 right now? What you are seeing among your customers? Are they trading down or they -- anything we can see...

Yes, I think, the overall demand patterns and characteristics of really all 3 of the businesses remain intact. On the residential side, because it's been a warmer start to the winter or middle to the winter practically at this point, heating degree days are down about 12%. Having said that, we still have a lot of the quarter in front of us. 50% of the revenue comes in March, and we're sitting here in the middle of February. So fingers crossed, I hope it gets really cold. So lots of furnaces, and we'll be on our way.

Right. And then you guys also talked about level-loading production a little bit more than in prior years?

Yes.

Is that going to be an ongoing dynamic? Or is that just because we're still coming out of the tornado?

Well, last year, I think it had more to do with the tightness in the labor market and a conscious decision that we made to hang on to labor and wanted to make sure that they were productive. So we produced inventory, and we're not -- as Todd often says, we're not selling lettuce. So we'll just burn that off in 2020. But it was a situation where we'll continue to evaluate that. That will be a little bit of a productivity headwind for us here early in 2020. But as we get into the second half, that will be behind us.

And then we've also heard from some of the other peers in the space that there has been a bit of an inventory overhang, I think, because of the slow start to the winter season.

Yes, we had a really warm summer -- or a really cool summer. So that really hurt us. That can, roughly speaking, impact demand, plus or minus 10%. Last year, it was probably a drag, significant drag on demand in the peak summer season. But once again, it's something that you burn off pretty quickly. The least of my concerns are working capital levels, and we're focused on other things.

Got it. One last one. 2 quarters ago, you talked about the Allied brand growing dramatically above that of the Lennox. But what was it in Q4? And is there any broader trend there?

There's not really a broader trend. I think some of that had to do with the tornado dynamic. Because we couldn't serve our customers with the high-end product that we typically would have had. We had lost share there. The Allied business was less effective because of the product that was manufactured in Marshalltown, was our Dave Lennox Signature Collection, which is exclusively the Lennox brand. So we're doing great things in that business. But that was more of a dynamic that I would tie to the tornado, kind of, cooler summer than I would anything else.

Understood. Thank you very much, Joe. Appreciate it.

Thank you, Gautam.