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

I think the -- no is the short answer. The longer answer is when you sort of think about the steps of commercial -- unitary commercial customer can go through, the easiest thing for me to do is just upgrade to MERV 13 or MERV 14 filters. So we see a lot of customers doing that. And you have filters in the system. You can move to what's called a MERV. It's a measure of how many particulates get blocked out. You can go to a -- and if you go too high, then what's called -- the static air pressure is difficult to manage, i.e. the air won't flow through the filter, not to get air flow into a building. So if you can go to MERV 13, maybe MERV 14 filter with existing units, it really has no problem. It doesn't have quite the protection that I just spoke about, but more like 95% protection still. The other thing you can go to is UV lights, which is a little bit more expensive. And the largest thing that you can do as a commercial customer is to bring in more outdoor air. And by standard, you have to bring in 20%, 25% outdoor air into a building already in response to CO2 buildup. You can bring in higher percentages of outdoor air, which allows you to avoid the buildup of COVID or other particles in the air. But to do that, it gets expensive quickly because you have to add more -- you can imagine if you're bringing in twice as much outdoor air, you need more conditioning power, i.e. more tonnage of rooftop to be able to handle it. And so what we've seen is customers do filters. We've seen customers do UV lights. We've been in lots of conversations with people. But I think most commercial customers, before they add both the capital costs and then the operating cost of adding a lot of outdoor air, they're going to wait and see how this all shakes out.

Yes. I mean, I -- again, I appreciate your candor on this because when we hear the other companies in the space, maybe in the applied space, they are breathless when they talk about it. But to your point, there is this -- go ahead. Sorry. Yes, please.

No, go ahead.

I was just going to say, because on the one hand, they want a system that's efficient, that's optimized for the setting that reduces ongoing electricity consumption. On the other hand, more fine filtration, MERV 16, what have you, requires a bigger unit that costs more, right? So...

I think what matters is the ability to have a very thoughtful conversation with your customer about the pros and cons, and then steering where they want. I mean, this swerves because it depends how COVID sorts out over the next few years. But even if I'm just on the side of the angels of what's good for society, I don't argue lowering energy usage matters, that lowering greenhouse gases matter. I think that's more catastrophic than increasing my outdoor air on a building. And again, it depends on the application. If it's K-12 and kids are in the room all the time, you can do one thing. If it's a big box retail, I mean, you can't cycle the air fast enough when people are walking through the door every second, right? So I think it depends on the application.

That's a really good point. And just to be clear then, so in resi, we have this fairly high ticket potentially relative to the system cost -- system price to the customer. In unitary, all this optimization, maybe better filtration, buying UV, what have you, any way to scale that relative to a normal system that you sell to Walmart or whatever?

Yes. I mean, it'd be much smaller ticket. I'm not -- I mean, where it gets expensive is if they start adding more outdoor air. But if you're just going to add UV lights and you're going to add filters, it's 5% of the ticket maybe or less. So that's why customers are going to do it, but it won't -- what our applied guys are talking about, our applied competitors are talking about it, we're going to have to do a lot more than filters to sort of get the take-up that they're talking about.

Yes. One thing conceptually I was thinking about the other day was -- so let's go back to 2019 to this mental experiment, calls at a baseline of 100% in commercial. We thought -- I mean, we, meaning The Street, the world, whatever, thought commercial may grow low single digits for a couple of years. So in 2020, that would be 1.02; in 2021, it'd be 1.04 or something. In other words, it'd be about 4% higher than we were in 2019. And then, of course, we took a downdraft in 2020. Do -- how long does it take to get back up to where the hell we should have been, if you will? Because deferred replacement.

I understand the question. In 9/11 or after 9/11 and after the financial crisis, 18 months to 2 years. So it's much quicker than resi. So if you remember in resi, we talked about pent-up demand for years because homeowners just wait. But commercial customers, especially if you're in replacement, they are -- they understand the economics. So anything they deferred in '20 because of cash constraints or cash concerns, they'll want to do as quick as they can once they get the green light from their bosses to lower operating costs. And then they won't just push out the next cycle. They'll try and do both cycles quickly. And so I don't know if it bounces back. The market's down 20%. This year, we've guided for the market to be up high single digits next year. I forget if we said mid or high single digits, but sort of somewhere between those 2. And it comes back to second year, that gets back to the baseline. I think it could be faster than that. I think it's all going to be driven by the COVID response, quite frankly, that if we get to the summer and it's a green light, we're good. If we get to the summer, and we're all being whacked by the South African variant, then it may be a different story.

Okay. But that's a really interesting point. The point is, if -- let's just say COVID's gone, all of a sudden, middle of the year, we could have a 2022 that's substantially faster growth than what we've seen in 2021.

Correct.

The catch-up is there.

Exactly.

Okay. And then related to that, you guys have picked up some national account customers you met incrementally this past year, right? Can you talk about the size of this? How do we actually think about what the potential -- when you say we added 6, I don't know if that's 6 meaningful ones, if they're equally sized, if there's a big fleet wide operating day to day. How do we think about that?

I'll be very frank. We talk about it because it's to show momentum, it's to show that we're still winning. If we win a Walmart or we had a Walmart, we have Lowe's, we have Home Depot, if we win someone like that, we'll tend to talk about them by name. So these national accounts are smaller players. I think the more important thing, and we tend to talk about this every analyst meeting, is the percentage of national accounts that are non-retail. I think that's a more interesting number. And so I'm doing this in memory, so I may not have the math exactly right. But I think over the last 3 years, when we give these new national account numbers, 70% or so are non-retail. And so I think that's an exciting thing. Every time we're winning, we're diversifying. So I think it's less of -- or any of these whales, none of them are where we would, quite frankly, say that. It's a diversification. And that's a portfolio strategy that you win these customers, you're never quite sure who's going to win the race in some of these things. So we play a bit of a portfolio strategy.

And what are the big incremental non-retail markets you're winning in?

We're winning in distribution, so a company called Amazon, right? And so we're winning a lot of business there that we didn't a few years ago. DockinaBox is a growing vertical. So not large health care but urgent care that are now sort of on every corner is a place we've made investments. And then there are a couple of the verticals that we're really focused on in national accounts.

Interesting. Okay. That's very helpful. The other -- and just to be clear, how the hell did these guys buy? Like when you're going up against all the big uglies, Carrier, Trane, what have you, what does it that typically kind of differentiates the Lennox bid?

I think there's a couple of things to differentiate. One is we have a dedicated sales force to different verticals. And I think at different points of time, our larger competitors have had it not, have had it, but we always have it. So sort of year in, year out, we have the knowledge, we're calling the customers. We know that we have, not only dedicated national account salespeople, but dedicated by some of the verticals I talked about. I think that matters. I think the flexibility that we have on our unitary equipment, the fact that we have the highest energy efficiency, we have the lowest noise, we have great control systems with the Prodigy, we have national account services that can support it, that we can package all that. And then third is the maintenance people, facility people tend to bounce around, and they remember who delivered and who didn't deliver. We have a very good factory in Stuttgart, Arkansas that just doesn't miss deliveries for national account customers, and they remember that. So those are the things you package and bring to the table for these customers.

That's great. That's interesting. The -- to switch subjects real quick on PartsPlus because that was a big part of the story prior to the tornado and was interrupted and now is ramping again. Can you again walk us through what's going on here? So the first year -- first 2 years, I think it was $2.5 million. This is kind of an average annual sales contribution from one of those. How has that evolved? What are you seeing on the parts and supplies non-Lennox product, if you will?

Yes, yes.

Talk about that.

Yes. Just sort of high level for people who weren't as familiar with the story as you are, Gautam, I mean, we build out the strategy of adding more wholesale distribution points. We're about 220 or so. Because of the tornado and pandemic, there's been a couple of years we haven't built any. We're opening up 30 new stores in 2021. It's great to be back on the attack again. These stores, as you talked about, their small footprint -- 3 people in a store, I think 2 out front, 1 in the back, about 25,000 square foot, 5, 10 in the front and the balance in the back. We get to operational breakeven in a year. So we're covering our nut. And at the end of 2, 3 years, as you said, we're $2.5 million, $3 million of revenue, about half of it is incremental. And the strategy, as you know, well know, is to serve customers, dealer contractors who are with a 30-minute driving radius to the store. When we lay out all of North America by dealer location, by demand, we think with the 220 stores we have, we're covering about 1/3 of the market. So we think theoretically, we could go as high as 600. I don't know if we get there, but we've said 350 stores, I think, by 2025 is the public number we have out there is what our aspirations are. And so we're going to continue to grow it. And then -- and you know this, but for others, I mean, the best strategy is one that works, that the other guy can't respond to. And it's not that we're geniuses. It's just -- Carrier and Trane did this decades ago. And Lennox are always just focused on very large well-capitalized dealers. A decade ago, we said, "Hey, we're going to compete toe to toe, built a Mexico factory, started lowering the cost of the product. We can compete entry level. So then let's put these stores in place for smaller dealers." And so the other guys really can't respond because they've already got out their distribution then.

Yes. And just I'm curious about the churn with it. Like -- so when we talk about adding 30, but there's a net number, like what typically happens to the ones that you shutter? How many do you shutter in a given year? What's sort of...

Well -- yes, from memory, we've shuttered in 15 or so over the last 2 or 3 years. So it's a relatively small number. And really, the thing that drives the shuttering is the wrong location. And so it's all [indiscernible] mistake, right? So you put it in the wrong location, wrong side of the highway, wrong this, wrong that. And so then the economics don't grow like we need to. We'd shut it down and open another one.

Okay. And you guys have talked about the parts and supplies revenue picking up like that being a focused initiative. Why is that essential? I mean, is it -- I presume it's lower margin than Lennox product. Is it just diversification? Is it because the customer needs it? I'm just curious. Like what's the logic?

Yes. I mean, I won't put it in the category of -- essentially, I put it in a category opportunity. And so when you sell other people's parts as a distributor, you make 50% gross margin on it. So you make -- you don't make all the factory margins. You make very high gross margin. It's accretive to our overall operating margin. And it's really the thinking that says we now own all these stores. We have all this brick-and-mortar. What else can we do with it? And we don't want to sell candy and that sort of thing. Being a one-stop HVAC distributor or wholesale location is what our customers want. And so they're going to be stopping to buy Lennox units still. If they have a repair, they'll pick up Regal Beloit motor and Emerson compressor and some copper tubing and be on their way, and we make good margin on that and so we want to do it.

Got it. No, that makes a complete sense. I want to -- in the 5 minutes we have allotted, I was going to just switch to big picture. I mean, so you guys have a $400 million buyback plan for the year. Typically, you do ASRs. Any sense for the timing on this or...

Yes. Our point of view on this, as you know, Gautam, so I'm not telling you anything you don't know, is we'll tell you the what, but the how, we'll sort of keep to ourselves until we do it. I mean, we've done open market buying. We've done ASR within the quarters in case there's blackout periods. It's been a long time since we've done it all in ASR for obvious reasons. So we sort of bounce around on how we do it, but we're committed to the $400 million -- at least $400 million.

Okay. At least $400 million. And just to be clear on M&A, nothing happened of consequence in terms of consolidation in the industry the last couple of years. We have some independents now, Trane and Carrier. What do you expect to happen over the next couple of years? Do you think some of the privately held companies, whether it be Rheem or what have you, break loose, do you think, JCI and Carrier get together? I'm just curious, if you were to opine as an analyst on what you think might happen, what do you think makes the most sense? And does Lennox participate?

Well, I think the thing that makes the most sense is to have Lennox participate. So I'm pretty clear on that thinking. I don't know. It's, quite frankly, up to other people. I mean, we're for sale every day. So if someone wants to buy us, come and get it for the right price, but it'd have to be a big number. And then the other guys, I can make in the passion cases I have for years that JCI is a commercial company and have an asset that's wasting away and put it in hand to someone who could optimize it and share with the benefits and how we want to structure the deal. And I think we'd be the natural player to do that because we don't compete with them on the applied segment so they could do something with us and not have to worry about it. But that's up to them. And then the private companies, I have no reason to believe they're coming loose. But if they did, we'd certainly be interested.

It was funny, we all did this mental exercise when Carrier was being spun of, oh, could Lennox ever team up with Carrier in some way in a reverse Morris trust and 20-80, Lennox the acquirer with 20% of the EBIT and all that. Would you guys ever think that creatively about deal structure, something that requires anything?

Yes. I mean, at the end of the day, we're about creating value for shareholders. And we have smart bankers work for us, too. And I mean, we'll look at any creative structure that we think will create value. Because obviously, you need people on the other side of the deal who want to do something.

That's fair. And then just broadly on the competitive environment, I know I asked it on the call with Carrier. They talk up reinvesting in the channel, reinvesting in the product. I've talked to Watsco. They seem to believe that Carrier has been more responsive and helping them with digital and what have you. I just wondered, do you see any -- have you seen anything that's different now that these -- now that's Trane is public as a stand-alone and Carrier as a stand-alone? Or is it more just how they communicate to the investment community versus what you see on the ground?

Yes. I -- we haven't seen much change. And then my words on what you just said is, from the time someone announces it from Mount Olympus till you see it in the fields is a long time. I mean, let's see. I saw Carrier missed on margins today. And so maybe their desire to help Watsco on digital get [indiscernible]. I mean, these things you have to do for years, and you have to be consistent with your investments year in and year out. And we've demonstrated that we can manage the P&L, make our commitments and make significant investments. That's the art of all this. It's easy to spend. It's easy to cut. Can you do both? So short answer -- I took a shot at a competitor there, I appreciate giving an opportunity. The short answer to your question is Lamanch ran Trane before he runs Trane now. And Carrier, we haven't seen much -- many changes.

Okay. I'm going to just look to the audience real quick who can -- they can submit questions to see what we have. Okay. One last one, if you don't mind, indulge me, if you will. You've got 3 resi production facilities. There was the tornado. It makes a hell of a lot of sense to have 3, unlike Goodman, which has 1. I'm curious, how has that production mix changed since pre-tornado to now? Is there more in Mexico, more in South Carolina? I'm just curious, like how do you actually -- what's the learning from that?

I -- and we actually have a fourth one that does coils for us in Grenada, Mississippi. So we have 4 resi factories. I think the answer is we built redundant capability in multiple factories. And so things that we used to only be able to do in Marshalltown, we can do it in Mexico. We continue to expand Mexico. As you know, in December, we talked about the third factory that we're in the process of building, moving more production there. So I think you have, for reasons that you just suggested, you have multiple factories. And instead of just having focus -- and I mean, maybe the learning was just having focus factors to do certain things, they all have to be sort of broad based. You can do multiple things. And so when you have disruption of problems in one area, you can move capacity to another. Although, I hope I never have to live through another tornado again.

No, that was awful. I agree. You managed it well. Thank you, Todd. Really appreciate the time, and best of luck today in your meetings.

Yes. As always, appreciate the interest of everyone. Thanks, Gautam.

Thank you.