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

Good morning, everyone. Welcome to Laguna -- Virtual Laguna this year. I'm Josh Pokrzywinski, the firm's U.S. electrical equipment multi industry analyst. With me this morning, joining live from Zoom, but Richardson, Texas, is Todd Bluedorn from Lennox. Todd, great to have you. Before we dive in, I do have to read disclaimer. And for folks on the line, you'll get used to hearing me say this all week. So if this sound automated along the way, bear with me. Please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/research disclosures. If you have any questions, please reach out to your Morgan Stanley sales representatives. With that, Todd, welcome. Appreciate you making the time this morning, hopefully, all safe and sound. Anything, just to kind of start us off that we should know, in terms of state of play in the business, big strategic imperatives, maybe take a couple of minutes upfront and just kind of walk us through what you're seeing out there.

I'll just give a quick state of the business. I'll let you ask the questions about strategic initiatives. In many ways, it's just a continuation of what we set after the second quarter call. At that time, as you recall, on residential, we talked about that we had a very good June, and that July was off to a strong start, and the weather has remained warm. The homeowner or consumers remain strong. We had very nice August. September, as we're partway through, and as you know, September is half the quarter, and so we're continuing to work through September. September sort of pivots from being tied directly to weather and much more about confidence of dealers and getting furnaces lined up for the cooling season. So we're in the middle of that. In commercial and refrigeration, I'll lump them together to talk about the end markets, we had talked about it sort of April, May that the order rates were down as much as 45%, 50%, and that they had bounced back, if you will, not all the way back by [indiscernible], but we're down 15%, 20% and that we exited second quarter with a backlog of down 20% from last year. That's roughly order of magnitude how the business has performed through August. And again, we're focused on closing out the quarter in September.

Got it. That's helpful. I guess just to kind of stay with resi, it's been truly an unusual year, right? I think if you would -- I have told you at the start of the year that we would have had one of the sharper recessions on record and certainly very high unemployment rates, albeit temporary. You'd probably have a more dire outlook for the resi business that one ended up happening. I guess there's a few pieces here. And as is classic with the sell side, I'll ask you the typical 14-part question. On, we have weather, we had some leaner inventories, I think, that you called out in the dealer channels to start the year. You had to stay at home, where people were maybe a little bit more aware of what was going on and probably a little bit more resilient homeowner for things like mortgage forbearance and some of the stimulus activity and unemployment that happened. So a lot packed into that. But I guess, maybe help us calibrate around what do you think the more important dynamics were as a function of why the business was more resilient. What would you worry about as being a tougher comp into next year?

Well, I'll talk about, I think, the things that supported the business this year. And we're going to -- I mean -- and again, that was down strong, if you will, dramatically April, May, has come back in June, and then in July and August, I've told you, it's been better. And so I think on a year-to-date basis AHRI numbers, the market is still down. So not as down as much as we thought it might be. That's for certain. I think there's probably 3 drivers. And you mentioned them, and probably, in my order, weather matters, right? And last year was a cool second quarter. This year was a warm second quarter, and third quarter has remained warm, up a little bit from last year, but 20% warmer than normal, so weather matters. I think the stay-at-home has mattered. You've seen Lowe's, Home Depot, other industries remain in there. I think about the life raft analogy, people are going to spend money on your life raft and I think people are doing that. And then third, compared to the Great Recession, in the Great recession, home value has plummeted and homeowners never talk this way, but no one wants to invest in a depreciating asset. So I just think it's much easier to make an investment in a $3,000, $4,000, $5,000 system when your home values have hung in there and are -- you still view it as a way to make an investment in yourself and in your total value as a homeowner. So I think those are 3 reasons. When I think about next year, we still -- our model still say, and I've been consistent on this, that we still have another couple of years of mid-single-digit growth. And at the end of the year, it's -- while we've had a couple of warm months and strong demand, at the end of the year, I don't think we're going to see the market up. We're still calling for the market to be down year-over-year on a full year basis. And so I think that gives us some tailwind for next year, and we still think it's going to be mid-single digits, all things being equal. I think the weather, we're praying for a normal weather. So maybe second quarter is roughly the same, third quarter, maybe a little cooler. Just the stay-at-home may or may not be there. But if people are no longer staying at home, then I think they're much more bullish about the economy because they're working, and unemployment is going down, and there's some momentum there. But I tend to view it as, as you know, almost formulaic with the 80% replacement market. We know when the units are going to break, we know they'll be replaced unless there's a reason not to. And when I think about 2021, I don't see -- I mean the big variable remains COVID. If we don't have a vaccine, people aren't working, we're yelling at each other nonstop as a country, then you can create a scenario where things aren't good next year. But otherwise, we're still -- we're optimistic for 2020.

Got it. And I guess that kind of brings me to my next question. Within that replacement model, which I think we've all run the math on to that and people come on different opposite sides of the spectrum on some things. But the point still remains that within that, there's like this decision tree of what a consumer can do. And one of the things that really surprised me at the end of 2Q was how well mix held up, which is kind of the opposite of repair, right? Like instead of just buying something, you're buying something with an extra bell and whistle. How -- I guess, just walk us through on what you've seen on mix. And what do you think that's trying to tell us about the consumer or the homeowner or replacement cycle or anything, just given that it seems to be kind of like a positive anomaly with the backdrop?

I think it's tied to stay at home. I think it's -- on the margins, someone's coming in and talking to you about do you want the indoor air quality package? Do you want the iComfort thermostat? Do you want humidity control? Do you want the low noise unit? I think you're more amenable to that, if you like, I'm going to be here 24 hours a day for the foreseeable future. It's probably worth making that incremental investment. And I think it's driven by that.

And then I guess on the other side of that same coin, replacement cycle sort of implies along the way, people say, I'm going to band-aid something if I just don't have the cash to make it through or I can get a few more years out of it. I know you guys track this pretty closely and probably a better data than the rest of us. Anything that you can tell in terms of repair activity this year versus other years? And was it far off of normal?

No. I mean, it's been consistent with what I said on the second quarter call, where equipment was up in June and July and spare parts were down. So we've not had a repair-versus-replace like we did during the last financial crisis. And I'm repeating myself, I think that's the invests people are wanting -- investing and appreciating asset. The last time, it was depreciating. And so I think people are comfortable doing. Now the variable that's not accounted for is that I'm often asked is the government subsidies for unemployment and how big of an impact did that have. I think we're going to have to see how that works its way through the system, but we haven't seen -- so far, we haven't seen any impact.

Got it. Anything that you guys can see on your end that those are a high percentage of ownership folks versus renters who don't really have a strong opinion?

Yes. I think it's what you're saying. I mean we don't -- I don't know that analytically, but certainly qualitatively. But people -- you can still own a home in America even if you're making $15 an hour.

And then, I guess, maybe just prospectively before we can move on from the resi side. As we transition into more of the furnace season, furnaces, I think of as being one that's less volatile because, one, they're cheaper and, two, your propensity to live without heat is probably a little less discretionary than air conditioning. I guess, do you expect it to be kind of more moderate or healthy as a function of that, especially since we're maybe a few more months removed from the depths of COVID?

Well, the cooling season has been a roll coaster ride, which -- big downs and then big ups. And then I think you're right, I think the furnace season will be more modulated. And again, we're going to just have to see how it plays out. But everything we've said indicates that they'll continue to buy. I think you're right about -- a guy told me very early on when I joined Lennox. It doesn't always get to 100 in Iowa, but it always gets to 0 in Iowa in the wintertime. And so there's always a winter. And so we're going to sell furnaces.

Got it. And then just pivoting it out to some of the bigger themes that work here. I guess one thing that's really changed this year. And we don't live in a vacuum, thanks to COVID, although maybe we should. The competitive landscape, obviously, with a newly liberated carrier, might look a little bit different. Anything that you've seen out of them either through commercial endeavors or the way they're trying to poach dealers or pricing that would tell you that this is kind of not your father's carrier? Or I guess, in your case, not your carrier.

No. No. I mean, there's been no real changes. I mean, in terms of pricing, I mean, along with Goodman, they're the market leader in residential. And so for them, leading with price is suicide for them, and I think they understand that. Again -- and it's also -- they have the same cost structure. We do a -- it's a variable cost business. It's not like we have a seal mill that we're going to keep filled up to cover our fixed costs, you don't lead with price, and they're not doing that. And also, Carrier in many ways, it was autonomous even when it was part of UTC. I mean the difference is Gitlin's there. And so he may have new ideas, and we'll see all the things he may or may not do. But the team still allow the same people running the businesses in their field offices. Those things don't change quickly. But for renters, we haven't seen much change.

And then I guess on your own kind of share initiative share gain, a couple of things stand out to me. First, you guys have had a few real bang-up years with Allied here. Not that you've ever had particularly bad ones, but I think the last couple of years, especially, have been pretty outstanding. I guess, one, what's driving that? What do you think the additional runway is? Are you doing something differently there? Because it doesn't show up at some of the December meetings. They're like, hey, a big push on Allied, but certainly, the numbers have started to build that out.

Yes. I mean we've made investments in product. We have a very good team there, run by [ Gun ] and Joe Nassab, good sales team, just good organization. And we've, I think, focused on it. And I think over time, things come together, our strategy with the Mexico facility got us a cost structure. And we're able to compete at the more entry-level product where Allied has more of a preponderance to play there. I also think, over time, the way we gain share in our Allied business is we win new distributors where -- in our Lennox business as we convert dealers. And some of the stumbles of our competitors have allowed us to convert independent distribution, York, for example, and that's helped us gain share by converting some big distributors, and it just takes time in that business because it takes a couple of years from the time somebody decides, think about moving to make the conversion over to seeing it in the P&L. And so we're seeing all the benefits of new business development initiatives they've had over the last 3 or 4 years. And I think it continues. I mean, our share in that business is relatively low. And so you can gain share for a long, long time.

I guess the -- who's left to really gain share out of, I think, of like the Carrier ICT brands, and Goodman have probably the dominant share there. York, I don't know if they have enough share to donate.

I think York has still enough share to donate. And you have them, you have REM, you have the second-tier brands. As you said, at Carrier, you have the second-tier brands, at Trane. And so you always have to remind yourself that we spend a lot of time on the premium brands, talking about premium brands, but 55%, 60% of all units sold are entry level. And so having basic brands, like we have in our Allied brands and competing at the mid-tier and entry-level tier is an important opportunity.

And then, I guess, maybe just to kind of round out the share discussion. A word that has probably been struck from the Lennox, Lexicon, [indiscernible] are we kind of fully past that?

Yes. No, we're absolutely.

New normal?

Yes. We're new normal. So we talked about that in the last year that we had converted 80% of the dealers back that we lost, and that we'd see a flow-through the P&L in 2020. We're in fact seeing that, plus gaining some additional share beyond that. So it's now behind us.

Got it. And those would be new dealers, not necessarily the ones you lost winning them back.

The winning them back is getting back to dealers that we lost. And so when I say 80%, it's the people we lost, 80% of them we got back. And then the additional share gain above and beyond that is dealers we never had, that the bad guys had, and we took it away from them.

Got it. And then I guess, shifting over to the cost side, and I'll admit some guilt here myself. Probably too much ink has been spilled over the years on price cost in the HVAC industry, where pricing powers, it's just good, right? So it's probably a bigger deal than it actually ends up being, but we are starting to see some of the commodities moving at fairly low levels. When do you -- how do you feel about how that trend looks into next year? Does that require you to be a little sharper on kind of January 1 increases? Maybe just kind of a broader commentary on the price cost environment.

Yes. I mean you know this, I'll say this for others on the line. Our major commodities are steel, copper and aluminum, roughly in that order. Copper and aluminum, we have mentioned on average, 12 months out, we're 50% hedged. So we have a pretty strong hedge position next year already. And then on steel, we buy both some fixed contract business, but also the majority of it is variable, and it's tied to the CRU pricing during the prior quarter. And then as you suggested, we've been very good at getting price. If there's a big commodity shock, you're going to have some headwinds, and you don't get in that price to offset it all in year 1. But over the commodity cycle, we're able to do that and get some additional pricing. And so I mean, where we sit now, I'm not concerned about getting price to offset any commodity headwind we may have. And if commodities continue to go up, that's obviously good news, right? That means the economies cook in and people need it. So I think in some ways, it's an equational balance, so...