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

Good morning, everyone. Welcome to the Lennox presentation. I'm Ryan Merkel from William Blair's Research Department. Before we begin, I need to remind you that a complete list of disclosures and conflicts of interest is available on our website. With us today is Todd Bluedorn, Chairman and CEO; and listening is Steve Harrison, Vice President of Investor Relations. We're going to skip introductory remarks and just go right into the Q&A, just to be efficient.

So Todd, first off, any update you want to provide in your business? I realize you have 2 big variables in COVID and weather, but what can you tell us?

Things broadly are unfolding what we talked about last time we were public or when we were public on the earnings call. I mean what we had called was for resi to be down 15%. And for the 2 commercial businesses to be down 25%, and that was the logic of one we just had to pick a number. And the real main -- one of the main reasons picking the number was to show we could do 25% decrementals, even on that lower volume. And so we've aggressively taken the $115 million of cost out, and we've done all the cost actions. And then in terms of the market, broadly speaking, it's played out like we thought it might, which is the planned replacement from commercial has slowed down pretty significantly as large commercial customers are waiting to have greater clarity and that the new construction, the projects that were underway continued, but sort of new projects are slowing down significantly. On residential, new construction projects continue to flow, the ones that were underway, and then it slows down, and we're starting to get to the end of things that were underway when COVID hit. And then the replacement cycle, as you know, Ryan, residential's emergency replacement, and so the unit breaks, they have to replace it. So far, we haven't seen the same -- haven't seen a phenomenon of repair versus replace that we saw during the financial crisis, but it's still a little early. The other thing we've seen, as you would expect, is where there's weather we've seen a pickup. So we've had some supportive weather here end of May or early June compared to last year, and those markets helped us. Where the weather is cool, we don't do as well. The economy in many places are starting to open back up. I mean that's obviously the huge variable here as to how that continues to open up. People today are a little bit more pessimistic maybe than what they were 72 hours ago with some of the new numbers, but we'll see.

Okay. A follow-up on that. A lot of companies are saying, as the states with harsh restrictions are opening up, they're seeing business come back with a bit of pent-up demand. Are you seeing anything along those lines?

Yes. I mean the thing -- one of the -- as you suggested, there's 2 variables, there are 2 broad variables in play right now. One is COVID, and the other is weather in our business. And through May, where we saw warm weather was the Southeast and the West. Those were the places that were opening up or really hadn't been hit by COVID. And where we had seen cool weather was Canada, the Upper Midwest and the Northeast. And obviously those are places that have been hit very hard by COVID or in Canada or following protocol. And over the last couple of weeks, we started to get warm weather in those other areas that were hit by COVID. We've seen some pickup in demand. So I think -- I'm not exactly sure is it opening up the economy or it's the warm weather that sort of picks up demand the most. I think they both have to happen to get back to normal run rates.

Okay. And just going back to the outlook for 2020, resi shipments down 15%, commercial down 25%. Just remind us on what the framework was. I know you said you had to pick a number, but what was the framework to pick that number?

Yes. I mean, broadly, the framework was, having lived through 9/11 running Carrier's North America commercial business and here at Lennox through the financial crisis, I had seen how the markets have reacted in the past. And so it's our sort of best guess based on institutional memory of how end markets have reacted. And again, it was a belief in resi that it would decline less than commercial because the nature of the demand is emergency, if it breaks, especially if people are at home and have to replace it or repair. Where commercial, given the 40% of the market's planned replacement, it's easier for them to defer the investment. And so it's -- the expectation was maybe a shallower decline in resi, but then you won't have the sort of same kind of -- when shallower down, shallower up, then get back to the starting point, obviously. Where commercial, it's steeper down, but then steeper back up. Now the caveat, to sort of not confuse people, but in resi, if the market's down 15% -- and you've heard me say this, Ryan, so this is for others. But if the market is down 15% because of COVID in 2020, that demand doesn't go away. It just gets deferred. And that annual 15% then gets spread out over the next 2 or 3 years. And so we're back to talking about this pent-up demand that we talked about after the financial crisis.

Okay, okay. This might be a little hard to answer. But in resi shipments down 15%, is a lot of that destocking? And then is new construction the other big driver? Because as you mentioned, the planned replacement or the emergency replacement stuff should hold up pretty well.

No. I mean, it wasn't tied to a little bit of destocking. But as you know, we own 80% of our distribution, and that's really where you're sort of doing it. I mean it was -- when I gave the number, it's a belief that, while we haven't seen it yet, there will be repair versus replace. So it was sort of what we saw in the financial crisis, where the market -- same thing there was emergency replacement, but the market went down 15%, 20% in '09 -- '08, '09, in response to the financial crisis because people repair versus replace. We haven't seen that phenomenon yet. I think the other dynamic that gives me hope maybe things will go better than it is, to me, the 3 macro things that drove the repair versus replace was high unemployment, low consumer confidence and then a crash in home -- existing home values. And so we have 2 out of 3 of those now, but home values have hung in there. And as you've heard me say, people don't use these words, but no one wants to invest in depreciating asset and homeowners won't or don't want to. But if there aren't a crash on home values, then I think they're more likely, if they can borrow, to replace the unit. And so far, we haven't seen repair and replace, but it's still early. I think we'll know more when we get to the summer selling season.

All right. And then on commercial, I know you said at the outset that it's playing out as you kind of expected when you gave the guide in late April. But what about the commercial backlog and order rates? I think you'd expected down 25% at this point.

They're down a little bit more than that. So I'm not trying to be cute. I don't know the exact numbers. I think it begins with a 3 for the order rates. But again, I would have expected that. I mean I think the full year number was 25. And I think most of us, at least when we gave the guidance, I would have expected second quarter to sort of be the toughest quarter as people -- this pent-up demand -- or excuse me, planned replacement just gets pulled back. And then as economies open up and -- better stated, as economies continue to open up, then I think it gets better.

And just peeling back that a little bit, you serve a bunch of different end markets in commercial. Are any holding up better than others? Or is it broad-based?

It's broad-based. I mean the ones -- our national account business, so large retailers, large grocery chains, sort of large national footprints, the planned replacement market is hit. Because they're sophisticated, they pull back. There's 40% or so of the commercial market that behaves like the residential market, which is emergency replacement. And so I run a doctor's office, the air conditioner breaks, I have to replace it or repair it. But economically, if it's better to replace it, then they do. So the sort of the flow business is done better than the planned replacement because that's where people have discretion. And then to just tie it off -- and I know you know this, Ryan, but this is for others -- what we saw, and I think I said this earlier, but I'll just repeat it. I mean what we saw in the financial crisis is commercial came down steep, and it really came roaring back because the pent-up demand in commercial comes out like in a year, where in residential takes 2 or 3 years to play out. And pent-up demand, once they get the green light and they know the world is fine, then these people who plan replacement will catch up on what they missed, plus what was scheduled for that time period, so you sort of have a couple of years and 1 year of planned replacement.

Okay. Makes sense. And then just a question on commodity prices. Just in relation to the original guide, do you have a bigger cushion as we sit here today?

Incrementally but small just because the hedges were almost all locked in because now we're on 25% lower volume, right, and so -- that we theoretically had 25% more hedges. And then even on the steel, it's roughly in line with what we thought. So a little bit more cushion, but not in a material way. We'll tune that up on the second quarter call.

Okay. And then shifting gears here. In a post-COVID world, do you see any opportunities for Lennox or the HVAC industry as a whole?

Yes. I've said some of our -- I know Landmark, Trane has talked a lot about indoor air quality.

Definitely.

And tied to COVID. We've always pushed into air quality. We'll continue to push into air quality, outdoor air filter systems. But the one point, at least -- I don't know if he's mentioned this -- is all -- those solutions all cost more energy. To bring outdoor air into the home or outdoor air into the work space just creates more air you have to condition, and so you're running harder. And even with a filter, it creates more energy usage. And so I'm not sure if customers pay for that once we have to the other side of COVID. We push it. We want to do it. We want to sell it. I also, again, wear my societal hat. I believe in global warming. I believe in global climate change. And so we want to push energy efficiency also or maybe more so. So -- and then the final point is, I don't think anyone has a huge competitive advantage here. So if the customers want to go that direction, we will take them there. On the resi side, we think we have the best indoor air quality. Consumer reports does, too, because they rate us as the top. And on the commercial side, we do all the things everyone else does. So if customers want it, we'll go there, but a trade-off is involved. And look, if we're living in a world, 3 years from now, where we're all wearing face mask and staying 6 foot apart, then I think that's the case. I'm more optimistic that we'll get a vaccine, get on with life here.

Okay. Yes. The indoor air quality was what I was thinking of. I have heard those little resi indoor air purifiers are all sold out with all the distributors.

Yes. Yes, they are. And so is toilet paper, but it's not all rational.

Good point. All right. What about -- how has your store experience changed due to COVID? And have there been any opportunities to provide higher service levels than maybe some of the…

Yes. As always with you, Ryan, that's a good question. And we're learning as we go. I mean we've always sort of thought about it as omnichannel, to get to the customer any way they want us to get to them. And stores will -- I think we'll continue -- certainly not that -- stores will continue -- new stores will continue to be a big part of our strategy, but we're learning simple things like in-stores or drive-throughs, like everyone else is, and sort of how to do that in the most efficient way, how to allow people to do the ordering online, pick up through the drive-through, never have to interact with everybody. So just like we're all dealing with food and cloths and other things, you can do that. We're figuring that out. We're all figuring out how to increasingly do the last mile ourselves. And so maybe just order at the local store, pick some stuff up, but then with our dedicated fleet, taking it to the building location or to the home location. And so we continue to play with it in that the LennoxPROs, our e-commerce site, is sort of the engine that allows us to go multiple different ways. So we're still going to build out the footprint, but we're learning different ways. I think like we all are learning different ways to interact with people that we buy stuff from.

And just sticking on that point, I saw in the deck that 40% of resin sales are online. Can you just explain a little bit mechanically how that works? Is that just a dealer ordering at night or ordering in the field and picking up at local?

Yes, it's all of the above. I mean the 40% is measured by purchases on our LennoxPROs e-commerce site. And in most cases, we always give the example, Frank, the technician, orders a unit. Frank, the technician, and most dealers is an ordering unit. There's someone centrally who makes those decisions and does the purchasing and has the expertise. And so we do a shorthand. But really, what Frank does is send a text to Johnny, who's the purchasing person, and says, "Johnny, I need this." And then Johnny goes online and orders in. And they sort of go out to the store and do it. So there'll be someone central. And so typically, what will happen -- I mean, they're all different. But if you're living -- you're not carrying inventory, you have people go out during the day on repair calls, you'll see what's wrong, what needs to be replaced, who's one -- got online and then you'll pass those orders and send them to us via e-commerce and then we can deliver to you within 24 hours or you can have your technician picking up on the store on the way to the job site, whichever way you want to be to get the product. And then the larger dealers will do batching orders or loading orders, and that tends to be -- they sit down and think about that more strategically. And so they'll buy 2 weeks of material.

Right. Have you seen the e-commerce channel increase recently, given what we've seen?

Yes. I mean we have. And I -- because some orders would take place across the desk, right, on some of the loading orders. Our salespeople talk to people, we do it. Now they're doing more of that on e-commerce. So yes, we have seen a pickup.

Right, what I would have expected.

I mean it hasn't gone to 60%, but I mean we've seen a pickup.

Right. And then big part of your strategy is investing in product what you would say is help to take share. Could you just give some examples of that for the audience?

Yes. I mean we're coming out with a new ultimate home comfort system for residential, which will have industry-leading efficiency, lowest noise level. We're proud of that. We're -- for 2023, in commercial, we need a whole new product line -- we're coming out whole new product lineup, and the first wave of that on the premium end will come out in 2021. And so it's investment by retiering our rooftops, which is around energy efficiency, around controls, around reliability and serviceability and some investments we're making there. And then while it's not products per se, traditional product, all the investments we're making on control is in right comfort, our Prodigy, which is our commercial controller, those are ways to differentiate.

Okay. So you've turned the page on the tornado issue, which I'm sure you're safe talking about -- safe talking about it. But now you're back to share gain mode. Could you just talk about who you're targeting specifically taking share if there's anyone? And then is your primary weapon the PartsPlus stores? Or is it really a combination of product, channel and technology?

It's all 3, right? So -- and again, it's -- there's really -- we don't sort of sit down in the center and say we're going after this OEM or this -- we don't sit and say, "Trane is the target" or "Carrier is the target" or "Goodman is the target." It's very much a local game. And so it's market by market. We understand who all the customers are. We're able to segment them. We have algorithms where we take the profile of each of the dealers who we don't do business with or we don't have 100% of their business, what they need, what other dealers who look like that value. And then that's where we go and sell. And so we're calling on these customers. We actually have a central team who drives new business development. We tend to do that in fourth quarter and early first quarter for the upcoming cooling season because that's usually where people will switch to product lines. And that's -- and so we've driven that. As we talked about coming out of last year, 2019, at the end of the year, that we've captured 80% or so of the lost tornado impact. That's flowing through the business this year just like we had expected it to. And then we turned on this new business channel midyear last year to go after new customers. And again, that's paying dividends. And then the other thing that we focused on after keeping our people healthy, our #1 priority has been to keep the product flowing. So we've aggressively worked on our supply base in COVID in the factories. We've had a few minor shutdowns in our factories, but nothing meaningful. We had enough inventory. So we have lots of product. We're shipping it even in the face of heat. Some of our competitors have had issues and are having trouble meeting demand, either because their supply base has been impacted or the factories like Goodman in Houston has been impacted. And we're able to -- we're not having those issues. And so I think that will have some impact on share also this operational execution of managing new factories and supply base.

Okay. And then you've talked a lot about the housing boom echo. And I think your models were resi shipments, a few years from now, it could be flat, maybe down 2. In my opinion, investors kind of overplay this risk. But could you just explain how that math works? And then I know you've said it's not -- don't think of it as a clip, right? So if weather is positive, in this year, that could overwhelm, right, the math of the…

Exactly. I mean it's -- a unit, that lasts on average -- or I think the median is correct technical term, is 15 years system before there's catastrophic failure. You know when the units were installed, and we -- I think we used 4 different regions in North America. So we just don't use the 15. And then there's a bell-shaped curve for each of the 4 regions, both for air conditioners and for furnaces. Because if you have a catastrophic failure, when you tend to replace the entire system, we're then able to understand how that equipment ages until there's a catastrophic failure. And then it's a bell-shaped curve. So units that were installed in 2005, they don't all break in 2020. Some break in 2012 and some break in 2032. And so there's this bell-shaped curve. And so the way I always think about it is, when I graph -- I actually get my fingers on some of these models just to make sure -- because I talk about them, make sure I understand them. As you sort of see the area underneath the curve of a replacement year as this bell-shaped curve and then you start stacking year after year of the bell-shaped curves 1 year off a phase over time, what that does is dampen the amplitude of 15 years from 2008. So in 2023, there's not a cliff because you sort of have this year's 18 on 1 curve, next year another curve, and so it waves itself out. And so when you model it, there's a year, as I said, it's down a couple of points. That's a rounding error, quite frankly, on the precision of the model. And then if there's a hot summer, you take care of it. And then now it's all going to be impacted by we're going to have this pent-up demand from COVID. That's going to sort of being leashed roughly in line with the same time that we would have seen the market be down a little bit. So the bad news is 2020 is going to suck. But you sort of get past down and look forward, all of a sudden, it's a different story. It's a story we had 6 or 7 years ago where we have some pent-up demand and the market's still mid-single digits for 2 or 3 or 4 years going forward.

Okay. That's helpful. And then maybe just explain for some of the newer investors that start on the call why is the HVAC market a great long-term market in your view. I know you've got a bunch of tailwinds that you can talk about.

Yes. I mean one is on the demand side that we talked about that then it's -- over the long term, it's a GDP-plus business because housing formation in the U.S. continues to grow. And so it's 3%, 4% growth business. The other is -- those who are familiar with the traditional Porter framework of what makes for a good industry: a handful of competitors, all publicly owned company or almost all publicly owned companies, same profit motives we have, all domestic players, except for Daikin, and then they sort of behave like we do as a public company; fragmented customer base, we're selling to tens of thousands of dealers; and then a fragmented supply base, where we're able to tap into lots of different motors and compressors and refrigerant suppliers globally because it's a global market. And then we're buffered because of this huge distribution network that doesn't allow other entrants into the market. So the Chinese that have invaded other -- that's a wrong term. Chinese who've entered other markets, it's tough for them to come in here because they don't have the distribution channel, and you just can't get going. And you can't make the product there and ship it in. And then the final piece is specifically on residential, to the end customer, there's huge opaqueness around pricing. And so you buy a piece of equipment every 15 years. It's different efficiency, different application and you would have bought a different unit you would have bought 15 years ago. It's also an applied product, so you can't go to Best Buy and say, "I want that one." You have there this byzantine dealer network come in and package it together. I mean you and I have the same house. But if my daughters have asthma and it's a southern-facing house, it's a different unit than you get even the same square footage. All that creates opaqueness. It's -- you can just get price in the marketplace. Who knows it's legitimate? We don't do that just to get pricing. We do it because that's the best way to run the business, because it is an applied product, but it creates an ability to get price with the end customers. So fragmented end customer base, ability to get price, relatively consolidated industry, barriers to entry from foreign entrants. That's why it's a business that we've said we can make 20% operating margins on and are already in the high teens. That's a good business.

Yes, I agree. Well, I often get asked the question, why does Lennox trade at such a big valuation multiple? And why do you…

You're telling leadership?

I was going to say management is my first answer.

Okay. Good.

Yes. But just do a compare and contrast. I think you get the question a lot. And part of my answer is always management, but also unitary versus applied. Yes, so it's…

I -- to me, that's a big answer. I think residential -- out of all the HVAC business, residential North America is structurally the best industry. And that answer I gave was a large part residential, if not exclusively residential. Unitary commercial, I think, second. It doesn't have the -- it has a fragmented customer base. There's a little less pricing opaqueness, and so it's a little harder to get price year in, year out than you can get in residential. But the other elements are the same. And then applied is much tougher. Applied are tend to be very large projects. You're bidding against each other. A lot more capital investments on compression technology to be able to compete. You have to have a large service arm. It's not quite razor blades, but they make a lot more money on their parts and service than they do on equipment. And then VRF is somewhere in between. And then mini-splits is just a brutal business, white goods business. I don't think any of the U.S. players manufacture anymore. And so that's -- I look at us and say we play in the best industry. And that's, I think, why we have and I'd like to think we execute. And so I think we get a premium for that.

Yes. The execution has been pretty amazing. You took margins -- you basically doubled margins, right, since you got there? What do you still have up your sleeve in order to increase margins further? Because I think the…

I think the material cost reduction continues. As you know, we do $25 million to $40 million a year, depending on the year. As we've done all these cuts, we haven't cut that at all. So sort of the whole machine that does our engineering and supply chain management to take costs out still up and running, including in our Chennai, India technology center that does a lot of controls, but also does cost reduction. We haven't touched people there. We're not done moving to Mexico. I've been pretty public about that. And so we have a couple of facilities in Mexico. But now that we have the new NAFTA behind us, we're not done looking at opportunities in Mexico, and I think that continues to be an opportunity for us. And then as we grow revenue, we've always focused on having SG&A grow slower than revenue growth as a percentage. And we took a big whack this year, obviously, but COVID -- but over the last 3 or 4 years, we've been pretty good at that and have got some margin there.

And just a couple of minutes we have left. Just hit on the refrigeration business a little bit. I think you have some regulation changes. You're expanding some access. You divested the business. What's the outlook there?

Yes. We -- I'll start sort of at the end there. We've gotten out of businesses we didn't think we can compete. So we're really a U.S. or North America player and a European player. We're out of Asia. We're out of South America. We're out of Australia. The businesses we have left, we like. As you mentioned, in the U.S., we're going through a major Department of Energy efficiency change this year, and we think we're very well positioned to do that. We leverage investments that we've made in our HVAC businesses around controls, around e-commerce to bring that kind of sophistication to the refrigeration business. In HVAC, we compete against corporate parents that are much larger than us. In refrigeration, where we compete, we tend to be the larger corporate parent. And so we're able to spread some of these investments in a way that others can't. And so we think we have some good businesses. We just, quite frankly, need to get some revenue to flow across the business. This is going to be a tough year because the market's in COVID, but we think we're well positioned going forward.

Okay. Well, we're out of time. Todd, thanks so much. Really appreciate it.

Super. I appreciate it, Ryan. And be safe. Thanks.

Thanks. Thanks, everyone.