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

Okay. Well, welcome to our next session this afternoon. This is Joe Ritchie, head up our U.S. multi-industry group at Goldman. Very happy to have Lennox International and Todd Bluedorn here with us, Chairman and CEO. Todd, thanks so much for joining us today.

Great. Thanks for having us, Joe. This is the easiest commute from LaGuardia I've ever had to your conference.

Great. We'll see if this is a trend in future years or whether we actually go back to physical. So far so good on this one. [Operator Instructions]

So maybe with that, Todd, you guys were one of the few companies to give guidance. So first of all, thank you for that, for helping to provide some goalpost to kind of navigate this backdrop. And in that vein, you kind of gave us an update on April with North America resi shipments down mid-teens and commercial and refrigeration down 25%. I guess it's been about a month since you guys reported. So to the extent that there's anything you can say to kind of give us an update on how things are trending, that would be helpful.

Just to reiterate or baseline on what we said on the call in April, we talked about, as you suggested, sort of a mile marker or guidepost that it's really, state the obvious, uncertain exactly how everything is going to behave. But we signaled that from our prior guide, markets were going to be down 20% and that we've had resi up 5%, and now we said down 15% as a market, and that commercial and refrigeration were flat, and we now had them down 25%, and that we talked about -- so the behavior would be that early on, it would be greater than that. And then later on in the year, you would expect some comeback. It wouldn't be flat during the time period. And we haven't seen anything that distracts from that. I mean I think there's still a lot of uncertainty. And even in our residential market -- or specifically in our residential market, there's multiple overlays. There's the COVID overlay and the impact that it's having on any given market. And then there's also the weather overlay because weather still matters and matters a lot. We had a relatively cool summer last year. And so there are some markets where we've seen weather, it's warmed up. And without being political, there's a COVID overlay of the economies opened up earlier and/or people were less impacted by it. So we've seen Southeast perform nicely relative to our expectations. And then on the other extreme, you have Canada, which matters to us, is an important market to us, and the weather there has remained cool so far, and they take the shutdown and the lockdown very, very seriously. And so wider bell-shaped distribution than we've seen -- I've ever seen because you sort of have both of these factors coming into play. And I think as we get through the summer, we'll figure out what are the weightings of each. I think they both obviously matter. And we'll see, as the economy opens up, what happens with the COVID impact. And as obviously, as weather heats up, it will be a positive impact also.

Yes. That's super helpful. And maybe just kind of going off that last point on weather. So as we were just kind of discussing, I'm in Rhode Island right now, and it's freezing. Like for May, it's cold. And so in your commentary on Canada, I guess, last year, I remember you guys talking about how weather can have like a 10-point swing on your organic growth. This is a much different market. I guess is that -- does that heuristic kind of still pertain? And then just based on what you've seen on a regional basis with your business or -- I know you had the easy comp with last year, but like are cooling degree days right now down significantly? I'm just trying to parse those comments out a little bit.

Not sure if it has the same impact. I think it probably does. I mean there's no reason that it shouldn't. So even if it's off a lower base, 10% still feels right, and that was always sort of a broad rule of thumb number to think about. Where we've had weather, the market has done well. So the direct question -- answer to your question is the great cooling days are down a little bit from last year, but not materially down. But it's been splotchy. So in the Southwest, California, Arizona, Vegas, they've had some heat, and we've done well there. We've had some heat in the Southeast, and we've seen that picked up. We're not selling much in Rhode Island right now and, as I said, Canada. But there's also this overlay of COVID, which is the Northeast has been hit harder than anywhere else. And certainly, again, without being political, I think people are more concerned and "believe it " more than other parts of the country. And so where we've had the market pickup as both weather and places where the economies opened up and/or they didn't have the same impact. And so it's a multivariable equation with at least 2 -- the important variables, I understand what they are, but I'm not sure the total impact that they have on the end market. And unfortunately, we won't know till we get a little further into the summer selling season.

Yes, that makes sense. Todd, like there's been -- we've been talking about the impacts from the tornado for some time now and your ability to recapture share that you lost during that time frame. I guess as I'm thinking about this environment that we're in right now, you can argue -- you can make an argument that it's -- it will be difficult for you to recapture share because everything is down a lot. But on the other hand, if you're operating well, there might be an opportunity actually to kind of outpace your competitors and pick up some market share. So maybe touch on that a little bit and how that kind of COVID-19 impact is potentially hurting or helping your ability to capture share.

We -- just again to rebaseline everybody, Joe, is we came out of the tornado -- better say came out of last year saying that of all the share we lost because of the tornado that were going to recapture 80% of it. And then we indicated or explicitly stated that a lot of that or all of that, quite frankly, had been either recaptured as we ended '19 or would be recaptured early in 2020. And what I meant by recapture was the agreements are signed, they're on board, they're ready to go. But you really don't see it start to flow through the P&L until you get into the summer selling season in a meaningful way. And so we're confident we'll get that 80% back that we said we would. And again, it's only 1 quarter. There's lots of moving pieces. But our -- when we look at industry data for first quarter, even with the -- it was a warm summer -- excuse me, a warm winter, so our revenue was down. But when we look at the industry data, our Lennox business gained almost 0.5 point of share in the first quarter. So after 1.5 years of sort of being down share, down share, down share, we were back on the share gain path in first quarter, as we thought we would be when we talked about regaining back the share.

Got it. That's helpful. I guess one of the other kind of dynamics I recall from your earnings call a few weeks ago was the fact that you had highlighted that dealers were kind of stocking up a little bit less ahead of the spring and summer. And obviously, we're in it right now. I'm just curious whether there's been any change in that dynamic over the last few weeks.

Again, the broad statement I would give is it has loosened up, and we internally caught a loading program. And the loading program has picked up as dealers start to get ready for the summer selling season. And again, it goes back to 2 variables I said earlier. It's a combination of, look, if you're in a market and it's warm and you're selling stuff, then -- which we have in parts Southeast, Southwest, then you're comfortable reloading and sort of getting stockage level. If you're in a market where people are still locked down and you haven't got weather yet, you're unlikely to want to do that. And so again, it's much more uneven than it has been in prior years where you only had one variable, you're accounting for weather. Now we have these 2 variables. And in many ways, in many parts of the country, they're co-aligned right now. And when they sort of break different direction -- so when the Northeast gets hot, we'll get a better read on whether there'll be sell-through even with COVID. And when weather cools down in other parts of the country where there's less concern about COVID, we just -- we'll get a better sense of how those variables are impacting the market.

Got it. Maybe if we kind of think longer term, Todd. One of like the programs that you highlighted at your Investor Day was the expansion of the PartsPlus stores. And I know that they're on hold right now and that investment is on hold for this year. But can you talk about what the longer-term opportunity is? And if it's possible, maybe talk a little bit about the profitability that each store would potentially add to your residential business or what it has historically.

When we put these stores in place, it's a couple of hundred thousand dollars of OpEx to put them in and the inventory to go with it. And then within a year, they're operational breakeven. Within 2, 2.5 years, they're somewhere between $2.5 million, $3 million of revenue, where half of it is incremental. And if you sort of do all the math on that, where we're starting at a high teens market share and you flow all that math, what it will do is once the flywheel gets going, 3 years out, if we put in 30 stores 3 years ago, that's worth about 0.25 point of market share just from building those stores and putting them in place. And again, as you know, Joe, for everyone else who knows our story that well, what these stores do allow us to pick up dealers and dealer business where they want to be able to drive less than 0.5 hour to a dealer or a wholesale distributor location that we own, pick up the unit, install it, get paid by the customer, not carry working capital. And when you look at the 250 or so stores that we now have, we cover about 1/3 of the North America market if you draw a circle around each of our stores of a 30-minute driving radius. And so that would imply that there's still 2/3 to go. I don't know if we'd get there, if that makes sense, but I know it's a lot more than 250. I also -- and we've internally talked this way. I haven't publicly used these words very often. But we've also been thinking about omnichannel, and the world may change somewhat because of this. And so we're prepared with our regional distribution network to be able to provide 24-hour delivery to anyone who wants it. We have our own fleet in many markets to provide that. We allow people to pick up equipment and parts at our stores now. In the current environment, they don't have to go in the store to get it. They can do drive-through. They can order online. And so the sort of omnichannel, whether it's through e-commerce and all the investments we're making there or physical distribution or the ability to travel the last mile, we're making all those investments and focused on making it easier for dealers to do business with us. And that's been part of our strategy for growth and a big part of our market share and will continue to be going forward.

Got it. That's super helpful color. And yes, obviously, something that I think we're all going to be paying a lot of attention to kind of over the next few years for you guys. I think maybe kind of shifting gears, staying on residential for just a second though. Just shifting gears to margins. I know that you guys have kind of stated that you're going to be managing to, like a, call it, 25% decremental for the rest of the year. The decrementals in 1Q were a lot higher than that. There's a lot of stuff going on in 1Q. Maybe just kind of provide a little bit more color on what you think was the biggest driver, whether it was mix, the pandemic, the weather. Like what really kind of drove like the higher-than-normal decrementals in 1Q in your residential business?

Well, I mean, one is we haven't taken any costs out yet. So the way -- our normal decremental drop-through, if we take no action, our variable drop-through -- our variable margin is closer to 40%, right? And so we -- the $115 million of SG&A that we've taken out of the business came too late to help with first quarter. That's one point. The second point is we had pretty significant negative mix in residential furnaces as our most profitable product line in the entire corporation and the furnace sales mix down because of the warm winter. And then also, residential new construction was positively impacted by the warm winter and AOR wasn't. So then you also had this mix towards new construction, which is less profit from us. But in terms of managing the 25% decrementals for the balance of the year, we feel pretty good about it. All the costs are out, and we feel we have an understanding on mix, and we're confident we're going to get a little bit of price. The decrementals in second quarter will probably most likely be a little higher than 25% just because, again, we -- some of the cost levers we didn't pull until partway through April, beginning of May, some of the restructuring that we did, some of the cuts in salaries, some of the zeroing out of things. And -- but second half of the year, we're confident and certainly on good decrementals and then 25% versus the planned decremental for the whole year.

Yes. That makes sense. And I think your -- just your commentary on price. I know you guys took down your pricing guidance. I think that's more kind of like a volume-related item more so than seeing any kind of change in price per se. But I guess, the resi business has been very disciplined over time. Is there any reason to kind of believe that you will have to make more concessions in this market from a pricing standpoint and just especially given the fact that input costs are down so much as well?

I don't think so. I mean during the financial crisis, we didn't have to. I think what we understand, and I think our competitors do, too, is when -- right now, there's some commodity tailwind. But if you cut prices, it's really hard to get it back. And -- but commodities will bounce back very quickly. So if there is a V-shape recovery, we're going to be talking about how much copper is up, how much steel is up, how the economy is boiling over and we can -- and commodities have gone up. And we won't be able to get price to offset that in 1 year, as you well know, Joe. And so you have to get a little bit of price every year to be able to offset the commodity fluctuations. And I think our competitors understand that. We certainly do. And then the other piece is when you look at our cost of goods sold and our competitors are the same, we're -- our cost of goods sold is 85% variable. We're not vertically integrated in any meaningful way. We buy compressors. We buy motors. All the high value-added things that are in our unit, we buy from others with our designs, in many cases, but we buy it from others. And so when you have to cut volume, you can take 85% of the cost out. You have some fixed absorptions you have to deal with, but we're not a steel company where you have this big, huge fixed cost asset that you're tempted to price at variable cost, we don't do that. And I think our competitors view it the same way. And so you have some absorption problems if the market goes down that you're worried about. But if you cut a percent of price that is worse to your P&L than absorption, and that also makes it difficult in following years to get it back. So that's why the industry is disciplined because it's in our own self-interest to do it.

Yes. No, that makes a ton of sense, Todd. [Operator Instructions] We do have a question from the audience, Todd. So it's about your commercial business. And so this person specifically wanted to know whether there are any buckets of your commercial business that you believe are potentially structurally damaged versus where you're continuing to see growth. And they referenced specifically on the call that you talked about some of your logistics providers helping to offset some of the headwinds on the unitary side of the business.

I don't understand the logistics supplier part of the question, so I'll...

I'm sorry. I mean I'll just say it more specifically. I was trying to be coy. But specifically, like Amazon and Walmart helping your business.

I don't think there's any part of our markets that are structurally damaged. I mean I think that may be a question about retail and some of our customers, are we worried about them and sort of our outsize -- historic outsized position in national accounts and retail there. I mean, look, Walmart is doing pretty well right now. Home Depot is doing pretty well. Lowe's is doing pretty well. Those are 3 major customers of ours. Look, retail is under pressure, and it's been under pressure for a long time. I don't think that longer-term dynamic changes, but I don't think COVID sort of changed the game. Look, we don't sell to Neiman Marcus. We don't sell to JCPenney. We didn't sell to Sears. So the people fallen to the side weren't major customers or customers, period, of ours. I think grocery has been -- or excuse me, restaurants have been hit, and some of those are customers. But not -- that's not a meaningful vertical for us in our HVAC business. And so I don't think there's structural change. About 30% -- 25%, 30% of our commercial business is -- is it -- I always get confused, Steve. Service is what portion of our commercial.

About 20%.

About 20%. I always want to exaggerate. 20% of our commercial business -- I should run for elected office. The 20% of our commercial business, that's service. I think that will do well. I mean, typically, when there's this big a downturn, the service business actually grows. And so we think the 20%, that is service will do just fine.

I'm glad Steve is there to kind of keep you on the straightened arrow.

Yes, yes.

Todd, you made that interesting comment from -- at the earnings call back in the day when you were running Carrier, that your commercial business back then, just you saw the marble just kind of roll off. As of a few weeks ago, I mean, your order rates were only down 10%. I guess the question is, like, have you seen the marble roll off at this point? Or are we still kind of hanging in there okay on the unitary side?

No. The order rates are down significantly versus 10%, and that's what I would have expected. The question is how quickly do you get out of the trough, right? So what I would have expected to have happened has happened, right, that planned replacement has sort of not quite frozen, but close to frozen, where people want to get clarity before they spend a lot more money. The new construction continued, and so what was there has flown or has continued to be delivered. And then emergency replacement has basically continued to flow, although they're doing a bit more repairs than they've historically done. And the planned replacement is just going to need to see some things open up, as I think they will, as we start to get back to work as an economy. And now we don't need to get back to 100%, but I think some of that needs to happen. And quite frankly, all that was encompassed by our guide. I mean, to say a market is going to be down 25% for the full year, when you're already through first quarter and the market was up, I mean, we sort of had baked in bad news, and that's in our guide.

Yes. That makes a ton of sense. I guess just talking a little bit about like the cost plan that you guys put in place. I think, very clearly, the $115 million plan, you broke it up into 3 buckets. I guess first question is what progress have you made on all the cost savings at this point? And then the second question, just to follow on, when we think about the structural versus kind of temporary elements, should we be considering, like, more than 20% being structural or really more like that salaried headcount component being the structural piece and the rest being more temporary?

First on, the implementation happened almost in parallel with the earnings call, so everything is done. So the salary freeze we had announced, but actually went into effect April -- or excuse me, May 1. All the restructuring took place within a week of the earnings call. And so everything is in line. So the discretionary spending, you see it as you go. But we've set the targets, we're managing it, and we know exactly where we're going to cut it. I mean at high level, if things get bad enough, all $115 million stays out and stays out for a long time. So I always sort of have that caveat. But I think about it as the pay actions, cutting people, the temporary salary reduction, cutting almost all the incentive compensation, except for some of our direct salespeople, you can't do that indefinitely or it's not temporary salary reduction. So the 40% that's tied to pay actions, I would view that as coming back in 2021. The other 60% discretionary spending and the salary headcount reduction, I think that's tied to what's happening with end markets. If end markets are still challenging next year, we won't add it back. If we can see some blue sky, and it makes sense to let some of that come back because we think the markets have recovered or are growing year-over-year, then we'll free some of it up. But the discretionary spending and the salaried headcount reduction, I think, stays out as long as we need it to. And as I said on the call, this is all tied to the markets being down 20% versus our last guide. And if it gets worse than that, then there's sort of another step function cut that we would do.

Got it. That's pretty clear. I think maybe kind of my next line of question, and it's something that's just like incredibly topical right now across industrial is the whole concept of reshoring. And clearly, the focus has really been for all of the automation companies. But clearly, like, every end market, every business could really benefit if, in fact, we do start to see a significant amount of reshoring here in the U.S. or even just localized manufacturing and supply chains globally. I guess the first question for you is how are you thinking about your own supply chain and footprint. Are you planning to make any changes because of this backdrop?

I think what we need to be able to do and what we've been forced to do, in some ways, because whether it's an issue in Mexico of some of our suppliers being forced to shut down or some of our suppliers in China early on are forced to shut down is on the fly. We've aggressively taken any part that was sole sourced or single sourced and have found alternative suppliers in a region or a market that can meet our demands. And so what I think would evolve would be -- look, I don't want to move a supplier back to the U.S. and pay 30% more for it. That's hard to imagine as the way to go. What I'd like to have is the ability of safety valve, either with that corporate parent or another supplier that if you need it, it's there, or you're dual sourced or you have other options. But look, we -- having a supply base in Mexico that provides parts for our U.S. facilities has short lead times at a lower cost point with the same quality or buffering it with inventory, but sourcing it from Southeast Asia, that's a pretty good model. And I don't want to overreact to the COVID crisis. And I thought we had a new NAFTA agreement, so Mexico, we could do trade with, and hopefully, it stays that way. So I'm not willing. I'm -- we'll dual source in the U.S., but I'm not looking to pull back our sources to the U.S., unless we have to.

Yes. That makes a lot of sense to me. I guess as you -- so that was a very specific question to you and your businesses. But I guess as you kind of think more broadly around different end markets and whether that's in life sciences or tech, and yes, that could ultimately have...

I think it absolutely could, but I think it may be because the government helps them make that decision.

Sure. Okay. Fair enough. And maybe kind of switching gears a little bit. We haven't talked about refrigeration yet. Pretty diverse business for you. I have it, call it, roughly 25% to 30% of your business tied to supermarkets and maybe 20% to 25% tied to restaurants. I'd love to hear kind of your thoughts on how that business kind of evolves over the next, call it, 12 to 18 months. And if there's any parts of that business that could come back quicker because of the type of demand that you're seeing in the business today.

The portion of the business that's cold storage, that's food service, I think some of that will flow as the economy starts to reopen. I mean the other slice to looking at it, as you talked about in verticals, and that's fair, the other way to slice the business is in North America, about half of what we do is through wholesale distribution. So another way to think about that is pieces and parts and subassemblies, and that tends to be emergency replacement, that tends to be a systems down where they're doing some minor retrofits. And then there's another piece of the business that's large projects, which is maybe 1/4 and another 1/4 of business that is OEMs, think like a Hillphoenix, part of Dover, display case manufacturer we sell components to. I think the wholesale business goes down last and then recovers quicker as more steady business. And then sort of new construction or large OEM, a customer like a Hillphoenix or large cold storage projects, I think that's lumpier and goes down quicker and goes down harder. And that's what we're seeing. Our wholesale distribution business is holding up much better than the large project business. And that's what I would expect.

Got it. That makes sense. And then kind of similarly, we talked earlier about the high decrementals that you saw in 1Q on the resi side of the business. There were also -- the refrigeration business got hit for a few different reasons this quarter. Maybe just kind of talk about those in a little bit more detail and then whether that starts to kind of reverse itself in 2Q and beyond.

Yes. I mean there were a couple of sort of onetime items in the first quarter. One was we had a couple million dollar EBIT impact because our European factories got shut down because of COVID. We also had this year-over-year refrigerant impact where we had sold refrigerant that we had for a profit that we weren't able to repeat in 2020. And so that -- those are the 2 major issues. Just like we've said, a 25% decremental for the corporation were probably worse in second quarter and a little bit better second half of the year. That was not only for the corporation, that was for each segment. And so we would expect a similar performance from refrigeration.

Okay. Fair enough. And then I guess, Todd, one of the other -- maybe just kind of switching to capital deployment for a moment. You suspended the buyback for Q2. Just any thoughts on like when you would get a little bit more, I don't know, aggressive or open the spigot back up on the buyback, if -- obviously, it's going to be very much demand-oriented, but any thoughts around that would be helpful.

Yes. I think there's a couple of things to think about. One would be, look, we're going to have strong cash generation, we showed you the $340 million, even with the sort of market characteristics we've discussed. In large part, that's because we're a distributed product business. And so when you have a downturn like this, we're able to reduce working capital, in line maybe even slightly quicker than our net income goes down. But that doesn't hold up forever, right? That magic sort of goes away after a year or so. And so I think it would be important given sort of the unique nature of the -- all of this and the uncertainty of how long it's going to last, to wait until there's a little bit more clarity that at some level of normal, whatever that looks like, it's starting to come back into place. And then you get comfortable. You'd hate to spend hundreds of millions of dollars of share buyback and then the next year need it for whatever reasons. I think the other point would be -- and less important, but still in my mind, is in an environment where we've done pretty aggressive pay reduction and salary reduction on employees, where we've, in essence, zeroed out incentive for executives and nonexecutives and almost for everyone in our corporation, except direct salespeople, it's hard to aggressively be doing a share buyback, at the same time you're asking your employees to share that kind of sacrifice for the company. And so I'd want to get to sort of greater clarity of what we were doing around that issue as well as what's happening with the end markets before we got aggressive in share buyback.

I totally agree with that answer. And obviously, I think it's the right thing to do. I'd be remiss if I didn't ask you the consolidation question, but let me ask it this way. Do you think anything happens over the next 12 months?

I don't think so. Maybe I shouldn't say that. Hopefully, a premium doesn't come out of our stock. But I mean, look, I think it, for a couple of reasons, to state the obvious, which is when valuations go down this much, it takes -- I think it takes longer than a year for people to sort of recalibrate. So I can't imagine anyone's going to sell on the cheap. And then I don't think any of our competitors would have a liquidity issue that quickly. I mean, Carriers is carrying the most debt, but I think it will probably take longer than a year for them to have liquidity issue that they might be forced to the table. So I don't think, given the valuation, that readjustment that's taking place, and the fact that it's not clear to me, anyone's going to have a liquidity issue. I'm not sure something, but I could be wrong.

Got it. On that note, Todd, thanks for spending time with us today. It's great talking to you, and hope you have a great rest of your week.

You too. Be safe and everyone online, be safe. Thanks.