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

Well, good morning all. 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 is available on our website at williamblair.com. With us today is Todd Bluedorn, Chairman and CEO. Lennox is a global leader in HVAC and refrigeration markets. The company has been a share gainer, driven by investments in products, distribution and technology. We're going to dive right into the Q&A here and skip the slide show.

So Todd, maybe just first off, any update you want to provide on the business related to either weather or supply chain?

No. I think it's very consistent with what I said during -- on the first quarter earnings call that markets remain strong. Residential continues to remain strong. I said that on the calls, it's true today. We've gotten some warm weather in parts of the country, and I think that's helped. Commercial and Refrigeration, order rates are strong; backlog, strong. From the supply chain side, I think everyone in corporate Americas working their way through supply chain issues. I think we're doing as good or better than anyone else in the industry, and we continue to work our way through it.

Perfect. And then just a follow-up. What's driving the strong replacement cycle that we're seeing in resi today? Is it anything beyond the typical core drivers of consumer confidence, rising home prices and financing?

I think there's a variable that we haven't quite quantified yet, but I think it's directionally helping, which is, I think, when people are spending more time in their homes, they're, A, running their units longer; and B, fixing -- replacing their units and/or fixing their units when they're break. And I think that bodes well for the future. I think we at Lennox, I think most companies are going to have some form of work from home -- increased work from home to what we had pre-pandemic. So I think that's a longer-term phenomenon that's good for the industry, that, quite frankly, will shorten the life cycle of the product, which will spend the replacement market even faster.

Yes. I agree with you. You probably saw the HARDI numbers, but they were off the chart in April, and that sell through, obviously. And it just seems like on the margin, people are replacing more than repairing. And I think the work from home is just driving that psychology.

I think that's true. I'd also have learned over the years that with all respect to our friends at HARDI that data can be spotty. I think it's tough to take a month to draw too many conclusions when you have 2 multiple ones.

Fair. It's not a huge part of the industry. That's...

Correct. It's a subset, I think, is a way to say it most respectfully.

Yes. Fair enough. Some of your OEM competitors have had production issues, both last year and I think, this year. So there's some shortages out there. Have you been able to take advantage? And then why is Lennox been able to ramp production and meet demand maybe better than peers?

Well, short answer is, we've taken advantage. We made a decision -- well, I think part of it's luck, quite frankly. I mean I'd like just credit operators to everything, right? But I mean, Goodman got hit by COVID at their Houston facility. Trane got hit by the polar vortex in their Tyler facility, that's just bad luck like we had 2 or 3 years ago with the tornado. I think part of it is just luck. But I would say part of it is having multiple facilities. So we have 4 residential facilities in North America. So when we were being impacted really by pandemic and people getting sick in our factories or staying home, being quarantine in our factories, as the pandemic hit different parts of the North America differently, we were able to continue to ramp-up in factories that weren't being impacted when certain factories were being impacted. I think that gave us an advantage. We didn't have all our eggs in 1 basket, I think that mattered. And then I think we're winning in the marketplace now. We have a very aggressive supply chain management. I think it's now also about the pandemic in North America, quite frankly. And more about managing electronics, managing steel, managing components, and we have a very good supply chain team. We're working very closely with our suppliers, and I think doing a pretty good job of it.

Okay. One of your competitors said recently that indoor air quality has never been more important. I was going through your slide deck, you have it in there. Just, Todd, what do you think, how material is this? And has it surprised you? Has it been actually bigger than maybe you thought 6, 12 months ago?

No. I think indoor air quality matters. I think it's mattered for a while. And some of our competitors talk about it, I think, relatively breathless, maybe it's a much larger opportunity in applied. I think in residential and unitary, I think it's a meaningful opportunity. I think it's about having the right product offering, which we do, build better homes is our initiative in commercial. PureAir is our product line within residential. Both of them have the ability to eliminate particles the size of COVID-19, 99% plus. So we have the right product. We're positioning with the market -- within our customer base. I think where it helps -- and then we're selling it, and our sales in residential were up, I forgot the exact number, 30%, 40% in the first quarter versus prior year. So it's up. And I think we'll get our -- more than our fair share of it. But I think as the pandemic starts to fade, and it will go back to what indoor air quality is traditionally been, which is if kids who have allergies, if you have animals in your home, so different reasons. And then it's also -- to us, it's any conversation that starts with, can you talk to me about your indoor air quality product is much better than here's the lowest price we got from your competitor, can you match? And so any time we're talking about a value proposition that's different than price, we love it. And so I think that helps the conversation. But I don't -- I saw some folks talk about indoor quality is a $10 billion market, I don't think so.

Okay. That's kind of why I wanted to ask your view. So next, I've got a 2-part question. So I'll ask the first one and then I'll ask the second one. So take us back, Todd, when you took over Lennox in 2007, I believe, what was your vision then? And how has it played out up until now?

I hate to be too retrospective because I'm much more excited about what we have in front of us. The second part, I assume that's the left job and the right cross, all these great things over the last 14 years [Technical Difficulty]. I think the initiatives remain consistent, and it is about driving factory productivity, and that was about the move to Mexico, and that continues to be the move to Mexico. We're opening a third factory there, and I've said we're not done going there. So it's about getting our costs in line with factories. It's about getting our costs in line with the components that we buy with others. And so that's our whole MCR initiative. And this year, we've had a lot of headwind, obviously, because of inflation. But that will level off and decline over time. We'll be right back on the treadmill of $25 million to $30 million of material cost inflection a year. And I think a lot of that's still in front of us. We're not done moving to aluminum from copper. We're not done with leveraging software to take out material costs on our product line. Third trend has been building out our wholesale distribution. And we've gone from 60 to 220 or so. We've set a target, as you know, Ryan, to get to 350 by 2025, and that continues to be a major initiative for us. And then also, there's been significant investments in digitization as we take costs out of our business and get closer to our customers and they intertwine ourselves more with our dealers. And so I think all those strategies in some ways have been what we've done over the past, those continue to be. And then either underlying or over top of depending on when we think about it is, it's a philosophy that we want to be big enough to be at scale, which we are, but we want to be focused on what we do. So we don't get bothered or sort of do new acquisitions or do this in that market or this in this market, we're focused on what we do. We don't do acquisitions in any meaningful way. Although, as you heard me talk about the changing industry, we would consolidate the industry. But we focus on growing organically and have end markets that are growing. And so I think that's been our recipe for success, and I'm real confident that's the recipe for success for the next decade or long.

Okay. Yes. The genesis of the question, this is what I get asked by the investors is, great, Lennox has done very well the last 10 years on share gain. But now you've got competitors that are now more pure plays, they've invested in product, is it going to be harder to take share over the next 10 years? What's your view on that?

I'll time travel to 2007. Believe me, no one said to me at the time, big carriers unfocused, and you're going to be able to gain share from them. It's carriers so much bigger than you, how are you going to be able to compete with them. They have all this aerospace technology that they can leverage in their product line. There's always an angle you can spend, focus wins. We continue to be focused. And I have a lot of respect for our competitors. But look, I mean, Trane got out of compressed air, but it's still the same leadership team that's always been there for good or for bad or for different. I got a lot of respect for the Trane team, but it's the same. Carrier by any other metric other than UTC still an industrial conglomerate. And when I hear that they're doing VRF acquisitions in China, keep going baby. Do 2 or 3 more of those because we're focused on North America res, we're focused on North America rooftop. We're not sort of worried about those other things.

Got it. Makes sense. Okay. And then on the share gain story, you've got the Lennox brand and you've got the Allied brand. Has one worked better than the other? Or are both of them equally driving share?

I think both of them are equally driving share. I mean over the last year or so, I think we've gained more share now, and I think that's for a couple of reasons. One is -- and the most fundamentally important reason is, as you gain share there in much larger swaths because you're converting distributors. And so very large distributors you convert. And our team was knocking on the door of some key distributors, we converted them, we got the business. I think the other is just the reported numbers. As we've talked about, there's some pull forward ahead, pull forward when you're selling independent distribution. And so the numbers looked a little bit better on Allied because of that. I think those are 2 reasons. But we're sort of agnostic where we gained share. Our EBIT ROS in both businesses are relatively the same. And so we'll grow either place.

Okay. So next question, could you unpack your digital strategy a little bit more? Just give examples of how the technology that you've invested in is helping your customer be more productive? And where do you see that going?

Yes. I tend to think about our investments in digital, and I'll talk residential because that's the easiest for folks to sort of talk about is, as there is investment on allowing the dealer to buy from us, we'll call that e-commerce, and then there's what we call LennoxPROs, which is entangling your business in other areas. So Internet of Things is sort of a buzzword that's used. So our investment in e-commerce is a little under half of our business is now ordered online via e-commerce, making it easy for people to do business with us. I sort of joke with the team, 10 years ago, everybody said they sold books online, but there was Amazon, there was everybody else, right, in terms of the user interface. And we want to make sure we're that. And I think Watsco is very good. I think we're very similar to Watsco. We think we're better. Watsco pricings are better, we're probably both, right. But both of us are materially better than smaller regional distributors who aren't making these investments. And this ability to order online to buy the ancillary products that you need for the installation, it's about being able to identify, you want to pick it up at a store, deliver to you. It's about being able to track a 4-hour delivery window to your dealer location to track it in, it's being able to buy spare parts and having the whole inventory of spare parts there to be able to find them. Those are the kinds of things we do in e-commerce. On LennoxPROs, it's the things I know you've heard us talk about but it's prognostics and diagnostics. It allows the dealer to gather the information on all the units that they monitor. We send all that information up to the cloud, back down to a dealer portal for their equipment. We -- with all our artificial intelligence and data that we've collected are able to tell them when a unit breaks, not that it's not blowing cold air because I think most people can do that at this point in time, it tells them what component. It's a compressor, it's a motor issue, it's a fan issue, it's a coil issue. Those are things that allow them to then make the fix when they arrive on the job site. And then we have -- on LennoxPROs, the dealer portal allows the dealer operations manager to see all the units in the field on a map. It pops up warnings on what units are broken, what needs to be done to address it. Those are the capabilities that we can provide directly to our dealer partners. That other -- even someone like Watsco, it's very hard for them to do all that because they have to rely on the OEM to give them the prognostics and diagnostics. And then they have to make the information available around the dealers. We're a unified front. We're able to do all that without an arms link transaction. Those are the kind of -- a couple of examples of things that we're doing that really help our dealers.

Yes. Yes. The preventative maintenance is really, really interesting. Do you charge contractors for that information? Or is that free to them as part of your service and value prop? And then how interested is the end consumer in actually buying the equipment that has that diagnostics? Is it small today? Or is it growing?

It's part of our value proposition. It's how we get dealers and then it's how we get them to stay with us once we have them. To me, the value proposition of preventive maintenance and diagnostic, it's never really been with the homeowner because that's a tough sell, quite frankly. If a homeowner, buy a new system, and when it breaks, I can read it online. That's a tough sell to make. But it's not a tough sell to the dealer because the dealer is a -- they get charged for fixing it right the first time they visit. If it takes 2 or 3 visits, it's on their dime and they know that.

Yes.

And it's always been the case in this industry. It's certainly the case now to have trained technicians who can do the diagnosis. And so if you're able to send someone out there and tell them what they need to do before they get there, it raises your confidence level you'll fix it right the first time. So it's dealers pushing for it and encouraging homeowners to allow the monitoring to take place or to buy the system, but the dealers are pushing it. That's how we make our money.