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

Great. Well, good morning, and thank you, everyone, and welcome to Day 2 of the Barclays Industrials Conference. We're excited to have opening today, Joe Reitmeier, the CFO of Lennox International. Joe, I think you've been coming for a number of years. So thank you very much.

Yes. It's like home away home, Julian, in February.

Good. Glad to hear it. And the -- maybe we'll open, Joe, with the -- just update us where we stand on the production aspect and the catch-up from the tornado, maybe what learnings have there been at Lennox around the pace of ramping down or ramping up production. Open with that.

Yes. In case you're not aware, our manufacturing facility in Marshalltown, Iowa was hit by tornado in July of 2018, which really took off-line our premium product for a period of time, resulting in us losing some sales. We recovered that through insurance, however. We're back in a situation where production capacity is back where it was pre tornado. We've got a nice new factory in Marshalltown, Iowa. There's -- we'll be putting some finishing touches on that in 2020 in the form of a distribution location and finishing that particular site and then some administrative offices. But as far as production capabilities, we're back to where we were pre tornado as far as production capabilities go. More on the commercial front of the business, we lost some share. We lost about $200 million of revenue over that 18 months. We caught back about 80% of that. And now we're moving forward, sort of dropping the curtain on all the implications of the tornado as we embark on 2020 and focusing on our growth initiatives, focused on product innovation, distribution, share gain. And that will be our focus as we embark on 2020.

And when you look at the -- how your competitors behaved in that period when you lost share or your plant was down, were you surprised of their behavior? Or did they act as you would have acted if the same had happened to...

No. There was blood in the water, Julian. So it's a situation where they had an opportunity to go out and win over some of our customers, some did. Like I said, we've got about 80% of that volume back, but once again, some elected to stay with who they worked with during the transition. And we're going to move forward from that and just, once again, get back, focus on our pre-tornado initiatives.

And the production facilities in Iowa that you mentioned, were you sort of -- the goal of setting up a plant very similar in production and automation and so on to what you had preexisting? Or there's some changes either in the volume output potential of the plant and/or the way the product was manufactured in terms of specification or automation on site?

Yes. Really since early 2017, we've been making investments in automation across all of our manufacturing facilities, particularly in the U.S. The facility in Iowa was one of our -- in fact, it was our original facility. Parts of that facility were 120 years old, so anything is going to be a step-up for some of that. But it's a situation where, yes, we have a more automated, probably more efficient plant than we did pre tornado.

And when you think about that remaining 20% share that you have not yet recaptured over 18, 19 months, what's the aspiration of the pace at which you get that share back?

Yes. We targeted here in 2020, a 50 basis point share gain, which will more than cover that 20% of lost or 20% that we're not getting back. It's a situation we're not going to focus on, that 20%. We're going to focus on going out winning new business with new customers.

And when you look at the pricing dynamics in the industry, you had some cost inflation that obviously pushed up prices 18 months ago in the industry. Input cost inflation, I guess, has moderated broadly over the last 12 months or so. Are you confident that this year you'll see another round of solid pricing when it comes to residential HVAC in the U.S.?

Yes. We, at Lennox, and most of our competitors go out with annual price increases, and the magnitude of that price increases typically depends on how commodities are behaving. For instance, in 2019, commodities were a headwind for us. It was a situation where we were able to get about 2% price yield. So we'll announce a price increase, a range typically between 2% and 6%, and then, once again, depending on how commodities are behaving, the yield is typically between 50 basis points to 200 basis points. We expect and we're targeting a 1% price increase yield in 2020, and that's what we're targeting. And once again, it's a situation where, as you mentioned, commodity costs have moderated and we'll have about a $20 million -- or excuse me, $20 million headwind from commodities.

And how about on the initiatives around productivity, aside from just what you're doing on price? You've got base inflation on wages and so forth to offset. So as you said, you had, many years ago, a shift of production to Mexico, then you've revamped the investment in the U.S. production base for 3 or 4 years. Maybe talk us through what's next in terms of major kind of productivity initiatives.

Well, once again, we target productivity to, at a minimum, cover inflation in the factory. So we're driving about a $10 million benefit -- we're targeting about a $10 million benefit in 2020 from factory productivity, and those are initiatives really across all locations. One of the things that we were able to do is stand-up a facility in Mexico about 10 years ago, and over that time, we've migrated production there. So what we manufacture there today is our entry-level heating and cooling product for our residential business. We'll continue to evaluate that manufacturing footprint. Once again, we're in a growing industry so we're going to have needs for additional capacity. We don't think we need to add more brick-and-mortar, but the question is where does that capacity go. And we'll continue to make that decision over time. We were threatened with cross-border taxes and all that, so we paused them on the Mexico investment back in 2017 until sort of the clouds parted on that. And once again, we'll continue to evaluate that manufacturing footprint and drive productivity and make decisions about where we put additional capacity.

How would you assess the -- how modern or upgraded the U.S. manufacturing base is? Obviously, you've got a brand-new plant on one of your largest sites. So that's clearly very new. How about the other production sites?

Yes. They're -- once again, we're largely assemblers so it's not sophisticated manufacturing by any means. We do some of our own fabrication in certain instances, but it's largely assembly. And where we can take advantage of opportunities, where we can make investments and see the returns in the form of productivity, we're going to continue to do that. And once again, we've made those investments in our U.S. facilities and even in some of our European facilities over the last couple of years.

There was a push that started to be talked about maybe 18 months ago or more around SG&A efficiencies, if you like. And SG&A as a share of revenue have moved up, and then the aspiration was to sort of put the brakes on that. Maybe update us on where we stand on SG&A and where you'd like to see that ratio to sales in the longer term.

Yes. Longer term, what we target is that our SG&A will grow at half the pace of sales. We're fortunate that we had some instances several years ago where commodities were a very strong tailwind for us, we're able to get price. We are still driving productivity gains where we could pull forward some investments. And during those periods, we grew in -- because we can afford it, we grew our SG&A at the same pace of sales. And we were able to pull forward investments in IT and R&D. We're seeing some of the benefits from that today. And as we go forward, once again, targeting SG&A growth at half the pace of sales growth.

And on the demand side, I think maybe what would be helpful is -- Lennox updated the sort of perspectives on the U.S. residential replacement cycle. I think many people try and have their own models. I'm sure some people in this room have some kind of model on that. Things are -- it's very difficult for anyone to get a good handle on that. I think most people thought the peak could have been 3 years ago, and it doesn't seem to be this year either. So it keeps being pushed out. Maybe explain sort of Lennox' thoughts on that and the sort of runway on resi replacement.

Yes. The punchline there is we still think we have 2 to 3 years of multiple GDP demand for residential replacement, largely the result of the echo of the housing bubble. It is the simplest way I can put it. And when you go back and look at the installed base over those years and assume about a 15-year life, no one's seen -- it depends on where you're at. If you're here in Miami, it's going to be a shorter life. But if you're up north, it will be a little bit longer life. But on average, about 15 years is what we believe. When you sort of lay those demand curves over the years, it really gives us about 2, 3 more years of, once again, multiple GDP demand for residential replacement.

And is that something that's -- you have a model internally. When you sort of cross-check with what either salespeople, distributor partners are thinking, is there a very broad spread of opinions on that replacement cycle?

Yes. Data is only going to get you so far. But it's a situation where -- we own our own distribution so we're belly-to-belly with tens of thousands of residential dealers and commercial dealers for that matter. It's a situation where the sentiment is still very strong with respect to both housing and replacement on the residential side.

How do you see this year shaping up kind of so far?

Yes. So far, it's been a bit of a challenge because heating degree days are down about 20%. So it's been a little challenging here out of the gate, but having said that, it's the first quarter. Our peak seasons are second and third quarter, so we still have a lot in front of us. And quite frankly, we still have a lot of the quarter in front of us because 50% of the revenue is generated in the month of March with our dealers and distributors on the allied side. So we still have a lot in front of us. But I wish it would have been a lot colder to start the year, but it is what it is. We'll look forward. We still have a lot in front of us.

And on VRF technology, it's been, I guess, slowly and steadily increasing share in the U.S. market. How satisfied are you with the partnerships you have there around the technology itself? And maybe give us some sense of any changes in the distribution approach. How satisfied you are with your progress on VRF in general?

Yes. The VRF is a new product -- well, not new. It's new to Lennox over the last several years, where it enabled us to partner with Midea who's the largest HVAC manufacturer in China. And they manufacture the product for us. We brand it and set the specifications for the U.S. market, and then we take it through our existing commercial distribution channels. So it's a nice add to the portfolio in that it enables us to penetrate certain vertical markets where, historically, we couldn't play because we didn't have an applied product. So it enables us to approach the smaller end of the applied HVAC applications with the VRF product. And once again, it's schools, it's hospitality, it's certain types of other institutional markets that enable us to bundle VRF with our existing unitary product and go on there with, quite frankly, a pretty competitive offering for those types of designs. A little bit different channel to market. Once again, you go through some specifying engineers and some other types of design-build type situations. But once you get specified, then the demand follows. So it's a good product for us. It's a nice add to the portfolio, and we're very happy with the partner that we have.

Well, do you have a sense of -- it's quite a -- it's an odd segment of the market because I think different vendors tie up with different technology suppliers. So adding up market share is challenging because you can be either technology owner or brand. Do you have any perspectives on where Lennox' share is in VRF today?

Yes. It's probably less than 5%, is where I would peg it at this point. It's a growing element of the market. Once again, it's been in -- here in the U.S. for about 30 years. However, it's a situation where it did sat on the shelf until the contractors and building owners became more educated on the benefits of VRF versus some -- once again, smaller applied systems. And it, quite frankly, has been easier to install; lower cost of ownership, which obviously appeals to the building owner; and then more easily maintained longer term. So there are advantages like that, that as, once again, building owners and contractors had become more familiar with the product, demand has picked up.

And I think on the very near term, at the last earnings call, there was some allusions by you and Todd to maybe first quarter starting out softer, not just weather but some cadence of production. Maybe just reiterate what that dynamic is, whether it's just a 2020 phenomenon or there's something in the company or the industry that you think this is longer term every year.

Yes. We typically don't give quarterly guidance, but there was a phenomenon that we are experiencing or had planned, quite frankly, in the first quarter that was different from our historical trends. And that was, as you look at the EBIT in the first quarter, it was typically about 14% on the full year. This year, it's about 11% for a couple of reasons. One, we have some headwinds that we wanted to make sure that folks understood. On the factory front, last year, in a tight labor market, we made a conscious decision to build inventory that we would then sell in 2020. As labor markets tightened, we were -- experienced significant inefficiencies on the factory floor from all the new folks that we had to hire. We had higher attrition because, once again, of the tight labor markets. So in order to hang on to that labor, we decided to invest in inventory in 2019 that we, once again, then burn off in 2020. But what it does is then it forces us to reevaluate our production plan for 2020. So it's a little bit lower as we embark on 2020 here, which results in lower absorption. So we're going to have a little bit of a headwind from there. We've got some incremental depreciation from the new manufacturing facility. And then as we're going out and winning back new share in 2020, it's different than the share that we lost. It was a richer mix that we lost and a lower-tier product that we're winning share with now. So there's a bit of a mix dynamic that we'll correct that as we go forward, but we're just facing those couple of headwinds here in the first quarter.

And the notion would be on the recapture in that lower tier, is that something that may be an aspect for 2020. It's not necessarily anything about medium-term share gains across tiers?

No. I just think it's a dynamic of simply what we lost versus where we're going out and winning as far as new share today. And once again, we'll correct that as we get further through the year.

And so the point would be, each quarter, you're coming out of that hole, if you like, steadily over the rest of the year?

Yes. Once again, by the time we get to the end of 2020, 50 basis points will get us to share -- a share level that was greater than where we were pre tornado. So once again, not focused on those customers we lost per se, but focusing on going out and winning new business with new dealers and distributors.

On the commercial side, maybe just give us an update on demand trends there. Very strong finish to the year, but it's lumpy particularly around some national account activity. Maybe discuss some of the main vertical trends you're seeing in U.S. commercial.

Yes. The sentiment remains, once again, pretty strong. We're going to have a situation where, in the verticals where we play, it's going to be a situation where the market -- we're calling for the market to be flat. But much like on the residential side, we have plans to generate a 50 basis point share gain, which will get us about 3 points of revenue. You layer on 1 point of price, so we're looking at probably anywhere from 2% to 4% growth in the commercial-facing business or mid -- near mid-single digit. But it's a situation where new construction is down. However, the replacement market, particularly planned replacement, remains very strong. And we saw that as we ended 2019, where some of our large national account customers proceeded and accelerated some of their investments. And once again, backlog remains strong. We remain very bullish there on the commercial business as well.