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

Great. Well, thanks, everyone, for joining. It's my pleasure to have now for our fireside chat, Todd Bluedorn, Chairman and Chief Executive of Lennox. Thanks very much, Todd, for taking the time, particularly given sort of difficult weather conditions. I was going to say it's minus 2 today and Dallas fireside chat takes on a whole new meaning. So I'm glad to see that you're looking well, and we hope that Steve who's dialed in is hanging in there as well.

So I suppose, first of all, Todd, yes, there's been a lot of gyrations in the market because in resi HVAC, because of COVID, weather always plays its part in mid winter and the middle of summer. So maybe just sort of level set us right now for where we are around the resi HVAC demand environment, a lot of discussion in the background around inventory levels and the whole selling sell-through aspect, which I know is less of a point of drama for Lennox. But nevertheless, Lennox also has had gyrations in demand and managing supply chains and so forth.

Well, I think the high level takeaway is demand remains extremely strong for us. And as you said, we -- 80% of our resi business is we own our own distributions. So we're not loading the channel or pulling forward demand. It's actual demand. I think it's in part driven by the cooler winter this year versus last year. And then the people staying in their homes. But demand is very strong. We ended fourth quarter strong, and we're halfway through first quarter and business and order rates remain very vibrant.

Understood. And if you look at the overall health of that residential replacement cycle, people are further trying to draw sort of curves and put points on curves on that. One, I suppose, understanding that it's very hard to do that, and it's not really a science, what are your latest perspectives on the health and longevity of that replacement cycle, sort of looking out beyond this year? And I suppose, drilling down to the nuance of HVAC specifically, do you see much prospect of a large prebuy looming late next year?

Julian, I mean this is for the audience. Julian, you know my opinion on this because we've been relatively constant on this is, I think, another couple of years of mid- single-digit growth when we look at the installed base, the aging of the installed base on which catastrophic failures that's what math tells us. And then even beyond that, just looking at historical life cycles, we think there's probably a couple of years where the market's down low single digits. But I would tell you that's our model isn't that precise. And so if it's a hot summer, the market is probably up. If it's cold summer, the market is probably down. We gain 0.5 point of share like we have, that's 3 points of revenue. We get a point of price, a point of mix for mid single-digit revenue growth in resi. So I think we continue to grow through the cycle. And then we get to the other side of that. For a couple of years, maybe it's down. And then we think the market starts to grow low to mid-single digits again, as household formation and sort of the normal installed base continues to grow. So we feel pretty good about it. And then in terms of the pre buy, there's a regulatory change that's taking place, as you know, minimum efficiency is going from 13 in the North and 14 in the South Air conditioners to 14 in the North, 15 in the South Air conditioners that will take place effective 1 January. I don't think -- I think there may be minimal pre-buy there tends to be -- or better stated, the bigger the jump in efficiency, the greater incentive there is to do a prebuy. And so back in 2005, 2006, we went from 10 SEER to 13 SEER, this 30% increase in efficiency was an effect of 30% increase in cost. And so there is real pressure for people to prebuy the low cost unit. So it's not to shock the customers. When you're going from 13 to 14 or 14 to 15, that's 7%, 7.5% increase, much lower increase, then you run in the risk of buying inventory you can't sell. And so I think there may be some prebuy, but I don't think there'll be prebuy in a meaningful way like there has been in prior regulatory changes.

Understood. And I suppose, Todd, as you look at the shape of the market right now in residential, replacement and aftermarket always the vast majority of the Lenox revenue base. As you are seeing that maybe a lot of bullishness out there on the new build aspect of the market, in general, not just in HVAC, of course, but this general concept of home building, having a boom, maybe could last a few years because of the interest rate outlook. And there are things that Lennox can do, in particular, to make sure that on that new build portion, it's getting more than its fair share of the market. Some of your competitors, Carrier, for example, always says that they have a bigger OE weighting in their mix than some of the peer companies. So just wondered what your perspective was on getting Lennox into that position to win there?

I mean if you look at national builders, we do business with 50% of the top 30 national builders. So we have an outsized position with new builders. I know Carrier does, too, but we have a strong position. We think our -- owning our own distribution gives us a big advantage. So if we're doing business with a nationwide homebuilder, no matter where they do business, they just have to deal with us. They don't have to deal with an intermediary who gets in the way. We made a decision 10, 15 years ago to get very competitive here. That's -- when you think back about the Mexico factory, all the material cost reduction, redesigning product in part's been about being margin -- at least close to being margin agnostic on entry-level builder business as we are on our traditional premium business. So we're good here and have been -- have an outsized market share there, and we like the business. But I think all of us learned from the housing boom, the new construction is a bit of a drug in that replacement to sort of the constant growth over time. And we have some herky-jerkiness right now because of COVID and loading the channel, but the replacement business is a much more stable business, obviously, over time.

And if you look at Lennox' market share, as you said, you have that steady increase aspiration annually. Maybe recent years have been more complicated, nothing to do with Lennox, but more around the tornado that happened to, then COVID that happened to the whole market. Are there, I don't know, learnings or things that occurred during those events or following those events that have maybe changed anything strategically at Lennox about how you go about growing share, working with your distributors, looking at market penetration in different respects?

Very British way to describe complicated as an adjective to use. It's been very complicated. I think a couple of things that we've learned. One lesson we learned, and we used it during COVID is we learned coming out of the tornado dealer business that we lost, which dealers were easier for us to win back and which ones were hardest for us to win back. And so I mentioned that in the cadence or sort of in the conversation that Goodman had real issues in production in 2020 and we were very thoughtful about what dealer business we would pick up because we didn't want to just rent the business for a summer and then have to go right back to Goodman. And so we understood why dealers would switch and stay, and we tried to take advantage of that. I think the other one is just maybe just an obvious point, it's much better to be on the offensive and attacking rather than in the defensive crouch in which we were. And so we're really excited about opening up 30 stores this year, getting back on the attack on our PartsPlus strategy. We're also really excited about getting back on the attack on -- with the existing stores that we have, increasing the percentage of the mix that's parts and supplies. And we're back on the attack on that this year after not doing much during COVID and the tornado. So those are two initiatives, we're back on the attack and we're excited to be there.

Interesting. And on the PartsPlus point, I think you've talked about that 350-plus count by 2025. Maybe help us understand how to think about that conversion into incremental revenues, the sort of dollar per store framework that people should have in mind. Again, understanding this program has been underway for some time, so you've probably got quite a precise view of the sort of range of outcomes.

Yes. We put a store in place. OpEx is about $300,000 to put in a store. We get to operational breakeven within a year. After 3 years, we're doing about $3 million of revenue in a store, about half of that's incremental revenue. And then about half of that's business we were already doing before, but the customers want to pick it up at the store rather than take delivery. So that's sort of the way to think about it. And so when you start to add 30 stores a year, you start to get this carryover of all this incremental revenue. And then it drops through at very nice margins, all the -- or all the drop-through is incremental to our overall EBIT ROS, such a low fixed cost to put these stores in place is $300,000. So it's a great strategy for us.

And if you look at that piece of the business that Lennox was doing already with the customer that isn't incremental, how does the margin for Lennox change as a result of them -- if at all, as a result of them getting it from the store versus the...

The honest answer is, the margin is about the same. You're trading a little bit of additional freight for a little bit of additional fixed cost of managing store. But broadly speaking, the margin is the same. And obviously, we like it because what it does is create stickiness with the customer. I mean, the more you can provide the product, however they want, the better off you are. And then on -- people talk about omnichannel, COVID really continue to push the learnings around omnichannel of -- especially for parts and supplies, ordered online, swing by our store to pick it up. We have curbside pickup or drive-through pickup, so you don't even have to face a counter person. I think a lot of those lessons, and then we also added local transportation to take it directly to their routing of their job sites. I think customers -- or the contractor customers will continue to expect that kind of delivery service and flexibility. And those are some of the lessons that come out of COVID for us.

Interesting. And if you look at -- you mentioned changes from COVID just now. People have talked for decades in HVAC in the U.S. and not just Residential now, but across the board, around ducted versus ductless and the emergence of VRF. Do you see COVID and its aftermath affecting any of those types of differences of approach or technology in the market? Or do you think the implications are fairly sort of agnostic across those and whatever trends you had pre-COVID are still in play now?

I think that's right. I think it's agnostic. I think our ability to provide indoor air quality is as robust on a ducted system as it is in the ductless system. I mean, I think let's look at Residential, with our PureAir system, we have with MERV 16 filters and UV lights integrated, for particles the size of COVID-19, it has a 99% plus effective rate. So we're able to screen it out 99%. And then air circulates in your home, if you have your fans running. And I would encourage people to have the fans running all the time, if you're worried about this is the air in the home gets circulated 6 to 7 times an hour. So every 10 minutes, the air is going through the PureAir system that has 99% effective on COVID. So I think if you do the math on that, you're pretty damn safe in the house unless you have people coming in and out, and then all bets are off. But we're pretty good at cleaning the air with our systems. So I can't -- you don't need to buy different technology to be able to do that.

Got it. And on the parts and supplies aspect, Todd, that's another facet of going sort of back on the front foot. A steep increase there, I think, almost doubling that business over sort of 4 years up towards $700 million-plus. What's the operating leverage like on that extra $300 million or so of sales, you think?

We're like most distributors. The parts and supplies, they're not -- well, better stated it, 20%, 25% of the parts and supplies we sell are proprietary parts and supplies, vast majority of them are other people's stuff, Emerson, Regal Beloit, Honeywell. And like most distributors, we get a 40% to 50% markup on the things we sell-through. And so that's normal distributor business. We don't get the factory margins we do on stuff we produce. So the answer is it's accretive to our overall operating margins and will help us grow our Residential operating margins to our 20% target.

And then if we switch to the Commercial side, partly because or largely because of their applied presence, a lot of your U.S. peers spent a lot of time and energy talking about attachment rates making the service more contractual and sticky on Commercial HVAC. Given Lennox' focus on unitary, how wide is the ability of Lennox to have that same increase of sort of recurring revenue or predictable revenue when you're doing that aftermarket in Commercial HVAC?

We have a National Account Service arm, our NAS business, and it's near $200 million in revenue. We've been growing at about 10% a year that focuses on large multi-facility customers that we're able to provide the preventive maintenance and repairs at a cost point that is -- it fits with it. The more technically -- I mean my experience doing this for a long time, right? I used to run the Carrier Commercial business [ to include the ply ] business. The more technically sophisticated the product is, the more [ USD ] OEM can be pushy with your customer about using you for service and tying it in. The less technically sophisticated it is and quite frankly, the more power your customer has, they just won't tolerate it. So the honest answer is a lot of people can do maintenance on rooftops. I think fewer people can do maintenance on centrifical2,000 ton chillers that are trainer or carrier selves. I also think the business model for applied is not a razor-razor blade, but more razor-razor blade than what the unitary business is. We make very good margins on equipment where the applied business makes their very good margins on parts and service. So there's just -- it's a different model dynamic.

Understood. And when you're looking at that unitary slope of recovery, beyond just the sort of financial guidance for this year, how are you thinking about that slope and shape of it, let's say, compared with what happened 10 years ago?

What happened 10 years ago is the segment of the market that -- really 3 segments to the market. One is new construction, and that hung in there both then and now initially for the first 6 months or so and then collapses. And that's what's happened. And then it takes years, I think, to come back. As it happened, I was at Carrier for -- Commercial for 9 11. I was financial crisis here. So it just takes years to recover. The others, local contractor business emergency replacements, a simple way to think about it, a unit breaks, you have to replace it. That never went down much, maybe 5%, 10% and then it sort of bounce back. And so that's trending up and is up already. The big swinger for us and the largest segment for us is planned replacement. That's the national account business to a large degree. And what we saw in the past and this year is when it happens, it drops marble off the table. We were down 60% in second quarter in our planned replacement business. And then when it comes back, it comes roaring back. And so because what happens is once they get a green light to start spending again, they make up what they missed plus what was currently scheduled. And I talked about on the fourth quarter call, exiting the fourth quarter, we had double-digit backlog. I used some language about the order rates were mixed. They're no longer mixed, order rates are very strong right now in our Commercial business. So we feel good about it. What we saw after the financial crisis, is it comes roaring back over an 18 month, 2-year period. And so if you remember, after the financial crisis, Julian, we spent a lot of time talking about pent-up demand in Residential, and it took 5 or 6 years for all that to play out. It takes 1.5 years, 2 years for it to play out in Commercial. They don't screw around. They know it lowers their operating cost. They spend the money, they upgrade. So I don't know if that second half of this year, it starts -- we stay on the COVID trajectory we are on now. That's what I would speculate. But now 2022, 2023, I expect the commercial market will bounce back strongly. And again, off a low base, we were down 20% in 2020, right? So that gives you lots of room to grow.

Perfect. And then Refrigeration, I suppose, a lot more portfolio shift in that segment in recent years. I suppose how satisfied are you with that -- the shape and size of Refrigeration today, do you think you have enough scale in European HVAC to win or it's an area you have to sort of bulk up to be in there in the long haul?

I think we have enough scale to win, but we would like to bulk up. So we need to grow organically. We have the right team in place, we have the right cost structure in place. And so we'll try and grow -- not try, we will grow organically. And if the right acquisition came along, I mean, we won't bet the company. It won't be multi billions. But if we could have a bolt-on acquisition to help give us more umph in Europe, we'd look for that. Our North America business in Refrigeration, we call it Heatcraft Refrigeration Products, HRP, profitable, strong business, industry leader in the markets we play. We've had some headwinds on the marketplace, but we like that business. We're going to look to grow that both organically. And if the right acquisition came up, we'd look to do it there, too. So the short answer is we like the portfolio. We think it's profitable. We think we can grow.

And the margin aspiration there, it's sort of low teens, I think, for the medium term. If that's really where you think they end up beyond 2023, is that high enough, attractive enough for them to stay inside Lennox? Or your point would be no, for them to stay in the company, there's going to be runway to a higher-margin level than low teens.