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

Operator, are we all clear?

We're clear. Go ahead.

Great. Good morning, everyone, and thank you for joining us. I'm Tommy Moll, analyst here at Stephens, Inc. We appreciate your time this week and willingness to come learn about some of the companies we cover. One of those includes Lennox International, which I'm delighted to welcome now to the stage, where we have CEO Todd Bluedorn; and Vice President of Investor Relations, Steve Harrison. Thank you both for joining us. I will proceed shortly with Q&A, and we'll spend the full 45 minutes focused there. I would note, though, for those who are participating on the investor side, if have a question you would like me to ask, there are two ways you can get it to me. The first, e-mail me directly, tommy.moll@stephens.com, that's T-O-M-M-Y dot M-O-L-L @stephens.com. [Operator Instructions] So without further introduction, we'll get straight to the Q&A.

So Todd, Thank you for spending time with us today. We appreciate it, and I think there's a lot to learn.

Good to be here, Tommy. Thanks.

Let's start with one aspect of Lennox that differentiates you from the rest of the peer group, which is your distribution strategy. And we'll talk about the more cutting-edge Lennox Stores debate or narrative, I guess, later in the Q&A. But just to set the stage for folks, what is the history of the company's owned distribution strategy? And how does that get us to your present strategy with the Lennox Stores?

Well, let me talk a little bit about the industry, and then I'll talk directly about us. It's in the HVAC industry, it's in other industries like electrical, it's 2-step distribution. So the OEM manufactures the equipment. There's an intermediate step, which is called a distributor in our industry who handles the product, manages it, warehouses it and then sells to the dealer contractor who actually installs it in your home. So if you call Frank's air conditioning, Frank is a dealer contractor, you won't ever interface with the distributor. We -- this is actually our 125th anniversary this year at Lennox, and we've owned our own distribution for 125 years. So it's not some strategic shift. We've always owned our own distribution. And historically, it's been just a fundamental bleed that you wanted to be closer to the dealers and that by owning your own distribution, you're able to do that. I would tell you -- I would have said 20 years ago, and I was in the HVAC industry with Carrier at the time, that you could go either model, you could go independent or you could go company-owned. I think it was important at that time just to pick one. And I would have said back then I always thought the cap model -- historic cap model have had independent distribution that was big enough to be powerful, but small enough that you had more power over them with sort of the best model. But a lot's changed in 20 years. And really what's changed has been the information technology. And so 20 years ago being a distributor was really about managing boxes, managing local relationships, going to church, going to school, going to football games Friday night with the local dealers you have relationships with. That's not how business works now. Now it's more about having artificial intelligence to make sure you have the right piece part at the right location at the right time for the dealer contractor. It's about having online warranty. It's about having online orders. It's about having prognostics and diagnostics. And so it's being able to make investments to leverage your national footprint, and we have that national footprint. And so does Watsco, by the way. But when you're a very large distributor like we are, you make all these investments and we leverage it across North America, and we're competing against smaller local regional distributors who carry our competitors' products. You just can't make those investments in the areas that I spoke about. And so 20 years ago, it didn't matter, quite frankly, if you're company-owned. I think in 2020, it's a big strategic advantage.

And if you could give us a couple of pages from the typical playbook when you look at a new market you'd like to enter, and there's a go, no-go decision on dropping in a new Lennox Store, what are some of the factors you look for? And then can you frame it in terms of numbers, what the upfront investment looks like, what the payback looks like, top line impact, et cetera?

Yes. When we talk about Lennox Stores, again, sort of tied together, it's different than a Sherwin-Williams store. Sherwin-Williams store that some people may be familiar with, it's both retail and wholesale. So I can go in there as a homeowner and buy stuff. In our Lennox Stores, it's just wholesale. So the only people who go into the store to buy anything are dealer contractors. We do -- in North America, order of magnitude, there's 100,000 dealer contractors, and we do business with tens of thousands of them. And those that we don't do business -- and most dealer contractors, by the way, carry multiple brands. So you're both fighting for new dealer contractors but also shelf space. For all the dealers in North America -- or almost all the dealers in North America, we have data on them, and we have an algorithm that rates them simplistically A, B or C in terms of how close we are to converting them. And we call on them and we gather information. And as we build out our stores, and as you know, Tommy, with rather -- we have about 220 stores, we think about the service radius of a store being about a 30-minute drive. It costs about $350,000 to put a new store in, OpEx. We get to operational breakeven in about a year. About 2.5, 3 years in, we're doing about $3 million of revenue, about half of it is incremental, about half of it we were already selling to other dealers, either direct shipment, now they pick it up at the store. But let's go back to the algorithm of how we find dealers or where we put stores in. We sort of understand all the dealers that are out there. We understand the A, Bs and Cs. We understand why they won't buy from us or why, better stated, they're ready to buy from us. And then we understand those dealers who, like our premium brand, are willing to invest in our marketing programs, want to do business with us, but they don't want to carry working capital. They want to be able to pick up the product in the morning, install it, get paid by the homeowner. And then what we do is we understand our market share in those markets. We understand how many dealers we think we can convert if we put a store in place, and then we rack and stack the geographical locations with all the data and algorithms that we put in place that we think have the highest payback for us to go into. And then the sanity test we do, quite frankly, is that we then add human element that we bring in sales management. And then they, quite frankly, get the bid with their quotas for the next year the stores at day one. So if I really am adamant about a store, as a sales leader that I'm willing to take on a higher quota from my sales team, and that's sort of -- sort of we bounce that against what the models tell us, and then we come up with a plan of what we're going to build for the next year. And we've -- as you know, Tommy, we've had a hiatus because both of the tornado we had and then the COVID crisis. But we'll start ramping up to 25, 30 stores a year starting again next year. We're actually opening stores in the fourth quarter as we speak.

And when you go into a new market and there's a share gain opportunity, by definition, there's a shared donor on the other side. So is there a typical competitive landscape that you like to go against? Or is that not as much a consideration than some of the other things you've already mentioned?

I think it is more about when you get a -- I tend not to think about it. At least I don't think about it at the macro level of we're going to go after this OEM or this very large distributor. We have enough micro data that we can do the segmentation at the dealer level or area level. And so -- and I guess what I mean by that is company -- OEM X, Y and Z with this distributor in this geography could be very strong. But that same distributor, that same OEM in this geography, they have poor salespeople, they've had quality problems. They've disappointed on technical support because of the local technical support team, that's where the opportunities are. So I think you need to think about it at that level.

Yes. And if -- you mentioned, Todd, I think you said 20 years ago, roughly, your view was more indifferent between company-owned versus third-party that currently, you've clearly expressed a view that company-owned is the way to go. If you go 20 years from now, what are the risks that could disrupt the middleman model, so to speak? I'm really thinking about potentially online platforms. But help folks understand the likelihood of something like that occurring, and what the potential impact could be from an OEM perspective.

Obviously, one of the sort of big risks to the industry is a disaggregation of us from our dealers. And so -- and the Amazon becoming a distributor. It's famous last words to say we're different, but I do think we are different. And we're different in the sense that one of the magic sauces of this industry that allows for such high margins is it's still very much an implied product. So anyone who's ever bought a residential air conditioning system knows that you and I, Tommy, can have the same-sized house, but my children have asthma, I have an east-facing house, you have a west-facing house. And so the requirements that go into the home of the outdoor unit, the indoor unit, coil, the furnace, sort of how it all comes together, the indoor air quality products, the controls, all packaged. And I compare that to white goods, which is residential, at least back in other parts of the world or washer or dryer. You can't go to Home Depot or Best Buy and see 100 of our air conditioners along the wall and say, "I want that one." You have to have a specialized contract to come out and help you pick it. The other thing that you have -- all to remember is that half the cost to the homeowners installation, the dealer has to install it, it has to be part of the selection, and then maintenance afterwards matters. So for someone to disaggregate us, Amazon, they'd have to build the relationships with those dealers because they need them to sell. They need them to install, they need them to support. And that's a much more complicated deal to do, especially when it's 100 degrees outside and everyone's units are failing, and you can't provide the aftermarket support because you haven't built the dealer network. And while we've seen a different way of disaggregation, a different threat would be international players coming in. At any time a Chinese player or a Japanese player who haven't bought Daikin or buys Goodman, that's different. But if they just try and come in greenfield, you can't build scale quickly enough around the dealer network to stem the bleeding that you have [ offices ]. So no one's really been able to come into the market. It's still the same competitors as the last 23 years.

Todd, I want to ask you for a short list on who the takeouts might be for a Japanese or Chinese buyer that wants to acquire a good beachhead here in North America, but there might be one.

I mean we're -- at the right price, I'll sell to almost anybody or I would. So -- but we believe -- the Board and I believe our 3-year plans would have to be a big number.

All right. Well, I want to dig into some of the specifics of your residential business, commercial business, cost out, everything. But to set the stage for folks, I want to go back to some of the early strategic decisions you made when you joined the company. Maybe the one to start with would be the cost out and manufacturing strategy that you've put in place that's enabled a lot of margin expansion over the last decade or so. But take us back to when you first became CEO, what some of the key strategic initiatives you engaged on were that have now borne fruit over that time period?

Well, and I'm going through that, Tommy, but I think all of them continue to bear fruit, right? I've had the privilege of being at Lennox for over a decade, I think it's close to 14 years. But the initiatives that we launched 12, 13 years ago are still paying huge dividends. And it's sort of the, quite frankly, the traditional playbook that I would learn in some place, that I learned at United Technologies, that you learned in a large corporation, which is you have to get your costs in line. And that cost control is sort of what feeds the engine of innovation and investments, but we have to get our costs in line. And so when I came in early on, we sold corporate jets and slashed SG&A. And the joke is our headquarters in Dallas, American Airlines can be our corporate jet. And we continue to focus on SG&A. But other things we did is we put together a very strong material cost reduction engine that every year, we get 2.5%, 3% net material cost takeout, and that's $30 million to $40 million of additional [ every ] year. It's gotten harder every year as it always does, but we built more muscle, we built the India Technology Center now about 500 people. And part of what they do is help us do that large engineering team here in Dallas, helps focus on it, then a very large supply chain team. And it's increasingly about designing cost out of the product, but it's also moving -- first, we moved to China, like everyone did, and then we're now moving out of China to Southeast Asia to India and also to Mexico. So the one is just sourcing strategy. The other has been our assembly strategy. We now assemble more than half of our units in Mexico, and we go to Mexico facility. We have 2 factories there on 1 campus and have space to add more. And we've haven't been shy about that, that we're not done adding capacity in Mexico, and we'll continue to do that. And then also in factories, as others have done a significant investment in automation, it brought costs out. So SG&A, material cost reduction, factory productivity has been the 3 major drivers of margin expansion.

Let's hit on residential, which is the biggest piece of your business. Help us understand from a geographic standpoint what states or parts of the country are you strongest. Where have your store expansions been clustered, if you can generalize in recent years, or perhaps where they might be going forward?

In terms of where we're strong in North America, I mean, I think we have equal strength everywhere. I mean there are certain markets. Certainly, we have greater share than others. It's just the bell-shaped distribution around any business. But we're not constrained in any area or don't have strong representation. We're well represented everywhere. In terms of the stores, there really isn't a clustering in any -- so we didn't say we're going to do the Southeast first or Florida or California first. And it just as I suggested, we understood where the markets and the opportunities were. I think one thing we learn -- we sort of learned 4 or 5 years ago was, instead of building -- if you have 4 or 5 different markets, instead of putting 1 store in 4 or 5 different metropolitan areas, it's better to sort of cluster because you had a symbiotic relationship if you had 2 or 3 wholesale locations, 1 market, advertising promotion, plus creating the local dealers. And so one of the things we've learned is just sort of back that a little bit. So if you go into D.C., you go in with 3 or 4 stores not 1, for example. I think most of the major cities, obviously, we're in, in and around, there's still penetration, obviously, is because the large metropolitan areas, if you have this half a mile driving radius -- or excuse me, 30-minute driving radius, you have to really penetrate the areas. And we're also sort of in secondary cities, if you will. The other thing I would point out, and you know this Tommy, about say, for the audience is, when we look at the total North America market, not population, but where the units are sold and we understand the dealer locations. With the 220 stores we have, we think we cover about 1/3 of the market with this 30-minute driving radius. So the implication is 600 or so is a theoretical number. We said 350 as an intermediate target. But there's still a long way to play out on this strategy.

Digital is a key theme for you on the residential side. And I wanted to break up the conversation into 3 components. So e-commerce, sales tools, technical tools. You've talked to all of those in the past in terms of investments you've made on the digital side. So maybe we take it in that order, and get folks up to speed on what the strategy has been there.

On e-commerce, that's really where our distributors' at. And that's making sure that our dealer contractors can order online. In 2020, we crossed 40% of our orders are now done in line with our dealers. It's about being able to not only have the equipment online, but all the parts and supplies and the piece parts and everything they need. We state the obvious statement, it's everybody does e-retail, but there's Amazon, right, in terms of wholesomeness of their product offering. And that's what we aspire to, and we think we're pretty good at it. It's also about them being able to track their order that there's a delivery window either to the job site or to their locations. They can track and pick it up. It's also about being omnichannel that they can, from their handheld device or their computer, decide whether they want to ship direct to them, whether they want to pick up the store to pick it up, or we also have trucks in our local stores that will take it that afternoon to your location. So sort of all those things are sort of wrapped up in e-commerce, also warranty support. On technical support, that's really wearing our OEM hat. It's also flowing through the distributor that we own directly to the dealer contractor. And the technical support on our premium equipment, maybe the top 40% of our product line that has our iComfort controllers, allows us to do diagnostics and prognostics on a unit that when a unit breaks, if you've given permission to the dealer to have access to the portal, they can look and understand what's broken. They can know what needs to be done to fix it. When they send a technician out, the technician can take it right out with them. We have lots of videos on our dealer portal also so they can look at the video in how to fix the unit before they arrive. And that really matters to the dealer, obviously, to the homeowner, too. But to the dealer, they get paid for the first visit, they don't get paid for the second and third visit. So all that technical support helps them. So that's the example of a technical support. And then sales support is half between OEM and distributor, because distributors provide a lot of support to the salespeople but we do that centrally in a way that a local distributor can't. And so with a tablet, they can walk into a homeowner, ask all the questions, complete it, show the good, better, best offering to the homeowner. Pick units, have the PO pop-up on the iPad, have the homeowners sign for it, get the credit card, pay for it. Automatically, it gets ordered and then it's -- they schedule the installation time for the homeowner. And so being able to bring all that [indiscernible] at the dealer level, we provide the tools to the dealer to then go in and sell. And then obviously -- not obviously, but online, we also allow homeowners to come into lennox.com, request information, ask for quotes. And we don't quote directly, but what we do is automatically feed it to our preferred local dealers who then will be able to provide the quote. So those are some examples of the 3 categories that you asked about.

So I had one follow-up on e-commerce. I think you said, Todd, that it's roughly 40% of revenue this year. Just to crystallize that for the audience here, does that look like a dealer who's in your backyard, sees what the need is, pulls out a mobile device, punches in an order and then drives to the branch to pick it up? Or how are those transaction closed online?

I think most of it's more of a central that Joe or Joanne or whoever is managing the supply part of the business at the central office on a weekly basis or a daily basis, however they want to order, they're off to their computer, they'll type in lennoxpros.com and order. What they'll also do, some dealers, the smaller dealers, if they're just doing a job by job, will do, as you suggested, from a handheld device to order it. Have it delivered to the job site or delivered to them. But I think it is probably more central at the dealer location, someone making decisions.

Okay. That's helpful...