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

Hi, good afternoon. I'm Josh Pokrzywinski, Morgan Stanley's electrical equipment and multi-industry analyst. Thanks for joining us for our Ninth Annual Laguna Conference, virtual this year, of course. I hope to see everybody next year. Joining me for our fireside chat up next is Lennox. And with us today is Chairman and CEO, Todd Bluedorn. Before we jump into Q&A and kind of the state of the world from Lennox's view, I do have a short disclaimer here. Therefore, any information about our research disclosures, please is at Morgan Stanley's research disclosure website at morganstanley.com/researchdisclosures. And then for all other questions, please reach out to your Morgan Stanley salesperson. Todd, good to see you as always, I wish it was with a cocktail in the hand for both of us, but welcome back to Laguna, all the same. Thanks for joining and what -- how are things? What are you seeing out there?

Yes. It's obviously good to be back, Josh. Demand remains strong across all our end markets. As you know, weather has helped us, and so demand remains strong. But we're facing significant production issues. And I've been saying all year that that's the case. And I still believe we're doing as well or better than anyone in the industry, but things worsened pretty significantly in Q3. Supplier shortages, integrated circuits, motors, compressor, steel, packaging, what I would call, fourth wave of COVID Delta variant has had impact, doubled our unplanned absenteeism. Our factories are in places like Arkansas, Georgia, Mississippi, South Carolina,. And if you look at where Delta's hit, that it's hit hard. And then third is the broader labor availability issues. So we're still working through the quarter, and we're fighting hard, but it's going to have a material impact on the quarter.

Got it. So I think a lot of folks who have -- we've had here so far, when you kind of described that supply chain environment is wacking on and it's certainly the free space in bingo right now, right? You can't really go too far without talking about it. If you had to sort of break down some of those incremental headwinds here, availability of product sounds like a big one, factories and labor, maybe another. How do you think about kind of that stack of pressures? Is it more on the cost to procure what you get or just the availability of anything period?

I think it's the latter. I think it's availability of getting it. We're willing to pay, our whispers our suppliers don't hear. I mean we're willing to pay premiums to get things. You can't get integrated circuits for many things that we need. And so we're frantically working with engineering to requalify, resource. Steel is very constrained. I mean that's flash steel cost 4x what it did 18 months ago as the oligopoly, which is the steel industry, is trying to keep supply down. So it's tough to get steel. And then the suppliers, whether it's motors, compressors, lowers their procuring parts, they're trying to manage their cost. And so what happens is suppliers like steel suppliers just won't make deliveries, because they find a spot buyer is willing to pay more for what was supposed to be our delivery, and that's rippling through the supply chain. That's first and foremost. Second is to an unplanned absenteeism in our Southern factories, unplanned absenteeism is as high as 15%. So you come in a very sophisticated factory and 15% of the people who are supposed to be there aren't there, because they either have COVID or they were in close contacts and that's 2x or 3x greater than what normal unplanned absenteeism is. And then the third 1 is [indiscernible] normal but labor shortages we've been dealing with over the last year. We've raised wages pretty significantly for starting employees. So that's in large part behind us. And some of the factories is still having an impact, but the order that I gave them is sort of the order of supplier shortages. It's just fourth wave of COVID and then to a lesser degree, of product availability.

So I think on the supply chain side, you guys have had strategic sourcing initiatives for as long as I can remember, certainly more than the last decade, with a good amount of yield on that every year. In this environment and nearshoring has been said so often now that it's sort of lost meaning. But are you rethinking some of what you've been chopping away at for the last decade and trying to move those relationships closer to home? Or is the requalification of the new suppliers just, I need the stuff from anywhere. So I'll look at that now, but maybe make some longer-term decisions later?

I think near term, it's about just requalifying or better say qualifying new suppliers to be able to meet the demand. I think that's the near term. I think there's been a multiyear effort that started with, I don't know if I can call them, the Trump tariffs, but the Chinese tariffs and laid on top of wage, and this is good, obviously, for China, but the wage rate increase as the middle class has grown in China that both of those sort of forced us or encouraged us to move the supply chain. And so what we source in China versus what we sourced in China 2 or 3 years ago is half of what we used to. And we've moved a lot of that to Mexico, which helps with the issues we're talking about, because it reduces supply chains. But we moved a lot of it to South Asia also, India, Southeast Asia. And so I think it continues to be a balance. I think if you have multiple sources, and I think in a perfect world you have a domestic source, you have an international source and you bounce volume back and forth depending on what's going on. And I -- we -- I think we and a lot of companies, you sole source, you convince yourself it's a small component. It doesn't matter. But what you're running into is now as you can't deliver a $20,000 rooftop unit, because you don't have a $10 integrated circuit that goes on the board that goes in your controller. And so making sure that you're multisourced on everything is a near-term priority, but then a longer-term priority also.

And on the labor component, I mean, obviously, not to diminish the human tragedy of it, and ideally, all these folks will be back to work here before too long. But does it make you think about the complexion of maybe automation or what processes in these factories could be automated going forward, because stuff like wage inflation probably won't go away even as the folks show up again.

I think we continue to look at automation and we'll spend money on it. But 1 of the beauties of this industry -- firstly, 1 of the beauties of our cost to [ cut ] our competitors are roughly the same, is 90% of our product costs are variable. Material, direct labor, nearly 10% is fixed overhead in a factory. And when you add more fixed costs to the businesses a seasonal, cyclical business like ours is, you can bleed pretty quickly in a down market. So I'm always cognizant about that. I think the better strategy is move to Mexico, and that's why we opened a third factory there. I think -- and this cuts against what some of our competitors do, I think it's to have multiple factories, multiple smaller factories, so you're not exposed to 1 event, whether it's COVID, whether it's a tornado. And so [ TOV ] with the high COVID rates has been very resilient to continue to produce product. And so we're glad we have a factory there. Other times, we may be glad that we have in Mississippi, Iowa, or Georgia. And so I don't think it's at a whole lot of fixed cost. I think it's that multiple factories and continue to move to Mexico.

Got it. And then when you think about sort of the competitive dynamic that evolves from this, because we're probably [ Audio Gap ] for Lennox on supply chain challenges. Are you seeing any big differences between company-owned and independent where maybe the independents have added more inventory or tried to add more inventory? Are you able to meet demand through 1 or the other better versus how you're positioned going into this latest round of headwinds?

I mean we haven't because we wanted to put as much in the inventory as we could over the last 9 months or last year even, we sort of knew this was happening in slow motion. And so we tried to get out ahead of it, it has gotten much worse over the last quarter. I don't think it's made a difference. And then whether you're independent or company-owned. And then competitively, I can see numbers through July, we've gained share in both businesses year-to-date. So we're "winning". I can see the numbers. And I think more simplistically, at different times, when I talk to the field, it's Carrier has issues, it's Goodman has issues, it's trained -- so it depends on the time and depends on the location of the factory. I think the broader question is competitively how this sorts itself out is we're all making customers angry right now. That's just the truth. And just like all our suppliers are making all of us angry. And so lots of angry customers. I think the market share shifts will be, a, how you treat them now; b, how quickly we recover and then c, how we handle them once the recovery happens. And so we'll try and hang on to our customers, but there's also a lot of angry competitors' customers, dealers that are out there for us to go after. So I think it's uncertain how it all stacks on competitively. We obviously want to get well as quick as we can because I think that's going to be critical to winning.

Just given where we're at in the season and things start transitioning to more of the heating season. Is there a risk to kind of that double-digit outlook just because if folks can't get product now, at some point, they're like, I'll wait or the fact they can't get product period, sort of brings down the ceiling of where demand goes? Or is that still on the table?

I think it's still on the table. I think we'll know better. I'm not trying to be too quiet. We'll know better as we get to third quarter and see where we're at. And so we're working through a lot of these issues. This is a short answer. But I would -- I'll wait till we see third quarter and then I'll update all the guidance, but I wouldn't take anything we said off the table.

Got it. And then mix has been another kind of interesting dynamic in the HVAC space, particularly. If I look across other building products industries, I'll say, mix has been a massive contributor. I think in the pool industry, it's been like 30 points just on mix. you guys were...

I upgraded my pump. So I think...

Everyone updated their pump. Everyone bought a new pump and heater to get 6 more weeks of pool season, never heard so much pool activity in all my life. But if I can trust that with what I see in HVAC, I think you guys had 4 points of mix in the second quarter. Now some of that is the offset of new construction. So I'm not blind to that reality. But -- have you seen kind of comparatively the type of mix support that you would have thought given the backdrop? And if not, what would you attribute that to?

I'm not going to give a macro answer, I'll give a micro answer, just our business. In second quarter and truly in the third quarter, we can sell what we make. And [ Sitio ] has done a better job of weathering the headwinds that I talked about, and [ Sitio ] makes more entry-level product. And so there are people, who were selling 13, 14, 15 Tier 2, who we could probably mix up if we had the product on Marshalltown or so I think that's part of the dynamic I don't think there's a mix down. I also don't think there's -- in pools, I think people are home, they're using their pool. They want to have sort of the new gee whiz thing, and so they proactively upgraded. As you know, in this industry, the unit has to break first. And so when the unit breaks, they make a decision to do. It's a much bigger price tag change. And still, I think people are less likely to sort of say, hey, honey, let's get that high end unit. I think that's sort of a more conscious decision that you're going to make.

Got it. And I guess that's a good segue and sort of my next question on the replacement cycle. You guys had an interesting observation on the higher run time with the iComfort data, which I sort of give is kind of a reflection of the best information any of us have at this point. What's your sense on unit failures kind of over the last several years? Have those accelerated dramatically? Or is more of the strength you guys have seen over the past 1 year, 1.5 years, just when a unit breaks, people are upgrading more often. So sort of this like the discretionary component of it being much more advantageous than it maybe would have been historically? Or are we just breaking this stuff way faster?

I think I'll nuance it's somewhere in between. I mean, for those on the call, who didn't hear me say this before, we looked at 175,000 units, which is what we can read from our iComfort and compare it to 2020 run times to 2019, and they had 30 -- adjusting for weather, 30% more run time hours. And that's sort of a linear life of a unit so I'm tying it as 30% shorter. I wouldn't expect all that demand obviously to pop within a year. What I would expect would be, which may be self-evident, as we said a unit last 15 to 16 years previous to this analysis, and there's a bell-shaped curve around that. To the left of the 15 to 16 years, nothing happens, it's under warranty gets fixed. What's happening is to the right of the bell shape curve, it starts to get pulled forward. And so units that might last 17, 18, 19 years, are now lasting less and so they get pulled to the left and closer to the beginning. And so it sort of shrinks to 12, but the 12 gets shrunk, because you're moving everything from the right of the bell shape curve to the left. I think equally important, and I just want to throw out some numbers is the R-22 effect. And you know this Josh as said for others is in 2005 to 2010. So those are 15, roughly 10 year old units, 60% of the units sold were R-22. It's a huge population of our 22 units. You have a 5-ton unit, it is a large unit. Well, you have at your home, probably, Josh, you have a 5 ton unit. You have a refrigerant leak and you have to recharge the whole unit costs $1,000 more to recharge the unit with R-22 than it does 410A. And so if you have -- if the unit is 11 years old, it's out of warranty or even in warranty, because warranty varies on a couple of refrigerants, because you have a leak, all of a sudden, $1000 will replace its old refrigerant. That's almost a way to think about that, that's a $1,000 discount on a new system. And so what we see dealers are doing is these units are leaking, they're breaking and they are doing whole system sales. And so there's obsolescence of R-22 and the spike in price is also driving demand. So I think it's both units running longer and this R-22 effect that give me confidence that the market is going to be strong. I know you all have a different opinion, but our -- we're pretty confident that it's hard to argue with those facts.

I think the refrigerant pieces certainly adds a lot of credibility to that view for sure, because that $1,000 a few years ago would have been what, $150, $200 maybe?

Correct. And as a good salesperson, I will come in and say used to be this, it's now $1,000. And do you want to guess what it's going to be 2 or 3 years from now? And you want to Band-Aid this unit, put a new coil on it and having you recharge refrigerant on this 11-year-old unit, or you just want me replace the whole system, and more and more people are saying fine replace the system.

Understood. I'm going to let the 5-ton in my house comment go, and I'll just say comparatively, it feels like ice on a window fan. On the -- so on the price increase front, I would imagine that at some level, despite maybe angry customers, its scarcity does give you maybe a bigger price envelope than what you would have expected otherwise. You had your third increase, I think, on September 1, if I recall that correctly, wasn't included in guidance, but just given the backdrop of what you've kind of mentioned thus far, even only a couple of weeks into it, I would imagine the uptake on that has been pretty solid, fair observation.

Correct. I mean, again, you got to remember on an annual or in an in-year basis, we're only going to have a quarter impact, if you will, in resi and in commercial, less than that. And prior to that, the price increase we were guiding. $110 million benefit of price, which is order of magnitude 3%, and it will be more than that with obviously with the third, equally importantly, it gives us tailwind of price going into next year. All that being said, there's remains stubbornly inflationary pressures on the business. And almost like -- if better stated, if commodities stay where they are now, we'll need another price increase in 2022, and we'll do that.

I guess, just to think about the timing on this, and we've been talking about this a lot this week is with things like hedges and contracts and all sorts of purchase agreements, we can all look at spot price rates, but the reality of what's the flowing through your P&L or even your inventory is probably a little lagged versus that. When do you think you sort of hit that max inflation number? Is that something that takes another few months before that's what's flowing through the business? Or do you feel like you're close to that today?

I think it's fourth quarter, first quarter. I mean if you just do the math of the hedge being 6 months and steel is still going up.

Right. Got it. Maybe pivoting to the commercial side, because that's a story where I think there's probably less market debate on or lack of visibility on what the long-term dynamics there. It seems like that cycle is bouncing back. You got indoor air quality, you got customers talking a bit more about efficiency or sustainability goals. The K-12 spending, the list kind of goes on. You guys have had pretty good growth in orders in the light commercial business coming out of 2Q. How would you sort of break that down as best as you can? I know at some level of orders are fungible, between kind of the cyclical recovery and catching up on stuff that didn't get done last year maybe versus some of those other longer-term drivers with duration.

I'm not sure how to put percentages on it. I think there's -- a big driver is market was down 20% last year, so then it bounces back, and that's what's happened when [ fund ] went up, commercial goes down. I think the other point I'd make is historically, sort of the rule of thumb is, 18 months, 2 years after new construction starts to spike, you see the unitary markets start to grow. And that's because, I think, obvious reasons you put in new houses and you've got to be able build to strip malls, you have to build doctors' offices, you got to do all that. And so new construction has been strong for a couple of years now. So I think that's also a tailwind on the new construction side. So commercial demand is strong, but I would even underline more for commercial than any other segment, the impact of supply shortages. I mean we have 1 factory. It's in Arkansas. It's been hard hit by COVID. Some of the supply shortages have impacted it. It's also as I mentioned earlier, it's easier to get the timing of pricing on resi is easier. I think I said on this call, I mean not I'll repeat myself, if I have to, but I will, is pricing and commercial is harder to get timing wise, you get it, but it takes a little longer to get it because of long-term agreements in the buyers and the customers. So third, fourth quarter, our margins are under pressure just because of that and the shortage of supply.

Got it. Any sort of line of demarcation between the national account folks who have multiyear strategies and all that sort of stuff around how they want to deploy capital versus the nonnational account business?

I don't understand what you mean by line of demarcation.

So just in terms of the way demand has come back, the conversations you're having, would the national accounts be included in kind of that post resi construction strength or are those folks saying, it's been a weird 2 years, we're going to wait.

No. It's part of the post resi new construction boom. But it's -- for national accounts, it's being swamped by, we didn't do anything last year on planned replacement. We need to catch up on what we did. And Delta's sort of slowed it down a bit, but they're still bullish. They're still spending lots of money. There's still lots of demand. The other business, again, there's new construction, but there's also the K-12 spending from whatever the right -- I forget the name of the bill. I won't say COVID bill but the recovery bill. And so we're seeing sort of across the board strength right now. And there's almost no vertical that we could sell more units if we can make more.

And then I guess 1 thing that's become way more topical over the past, I don't know, at least 6 months, maybe slightly longer. Is this kind of converge on building environment, more technology. You've got a few competitors launch IoT offerings and talk more about digital service. Now without an applied business, maybe some of this is sort of just looks different in unitary. But how does that discussion evolve? Obviously, you have some services exposure. You have controls. You talked about those at Analyst Days in the past. Are those a richer part of the dialogue today? Or is it still kind of a similar conversation as you would have had historically?

We made significant investments in controls and prognosing diagnostics, but we made a strategic decision to make it open protocol. And so we have what are called product level control, so we can read the unit, but we're not trying to do building automation. And so the building owner can bring in whatever building automation system they want, and they can still leverage our information on [ prognosing ] diagnostics. I understand the argument of IoT and tying everything together. As you know, I used to run Carrier commercial, I used to run [ Indiscernible ] America. These large building owners have a lot of power and they're not fools. So they don't want to have everything bundled with their HVAC supplier that controls building automation and has proprietary protocols. They like to have best of breed and be able to break it up, so they don't like to be bundled and tied in with anybody. And so maybe JCI can sort of bundle it all together and lock them in with proprietary systems, but my experience is building owners don't want to do that.

Got it. A question here coming in from the portal and admittedly on my list as well. Where do you think inventory levels are right now? And obviously, it's only 1 window into your business on the resi side, but maybe your best guess from speaking to those customers, how are inventory levels today and what would be their propensity to sort of add inventory at an odd point in the season, if they could?

It's lean, right, given everything I said about supply issues across the industry, it's lean. And so distributors want -- dealers tend not to want to carry inventory, but distributors want to buy inventory. Certainly, our distributors want to buy more. And we have dealers who buy from competitor distributors coming to us asking for equipment. Obviously, we can't meet their demand right now either. But everything we talked about around supply shortages and labor and COVID is affecting the whole industry. So it's lean. Now obviously, the good news is it's painful right now, but what that means is there are people who would be buying air conditioning now, they can't because it's not available in many parts of the country that are now saying, let's wait until spring time or wait until summertime. And so we'll have a running start on demand for next year.

And any thoughts from your perspective on how that colors the pre-buy dynamic into next year? I mean pre-buys have sort of gotten smaller with each passing generation here, but everyone will -- just kind of had the shell shock of like I can't get inventory and nothing feels worse than a missed sale. Do you think this sort of goes back to some of the bigger pre-buys we saw around other transitions?

I think it may actually have the opposite effect. I think it's going to be -- I don't have a crystal ball on the supply issues at rover, but I think it's -- it's obviously in 2022 at this point. And I think we're all going to be working hard to meet the demand that we need in 2022 and see in 2022. And so we typically mid-year next year start to prebuild. And I don't think there's going to be much capacity in the industry to do that. And so I think it's a combination. As you said, they get smaller and smaller, because it's now a 7% SEER increase. It's hardly worth taking the risk on the inventory to prebuy it. And I think the OEMs are going to have a hard time or they may have a hard time meeting demand just for 2022. And so therefore, we don't want to prebuild.

Got it. Switching over to kind of the portfolio strategy. as you all know, this industry hasn't exactly had a lot of transactions over the last several years. Certainly, no mega combinations that a lot of folks thought may happen at points in time, but you have seen some smaller stuff. JCI looked at the data center space earlier in this year. Trane went into something in the Life Sciences announced this morning. What do you think the aperture is or should be at Lennox over the next couple of years to start looking in some of these areas of, I'll call it, domain expertise to build out some of these niches where maybe the technology is a little bit more centric to that application?

Well, I'll give you my answer, which it's having a shorter and shorter shelf life on strategic questions, right? But my opinion on this has been consistent, which is if you have end markets that are growing and you can gain market share and you can expand your margins. That's how you drive your ROIC from 15 to 45, which we've done. And most acquisitions don't work. And even those that work, you sort of cover your cost of capital, maybe a little bit more. We made decisions that we'd rather -- takes a little bit more time, but we decided we wanted to get into controls in a major way. We didn't buy a control company. We added 500 people in India, and we built our own control strategies and build it out organically. We wanted to do VRF. We didn't acquire somebody. We just did a deal. I think that's an easier way to do it. Once upon a time, we decided we should expand into display cases that didn't go so well. My predecessors said, we should expand into dealers or service experts didn't go so well. So I think a lot of these things don't work. Right now, well cost capital to all these deals look exciting. We'd see how exciting they look in 4 or 5 years.

To be fair, though, I think the Hearth business will probably be doing pretty well today.

Good god, we didn't make any money even in good times. So, god bless whoever owns Hearth.

Well, I see we're out of time here. Todd, I appreciate the time as always, I wish it could have been on the beach, but good to see all the same. Sad that we won't have you at Laguna next year, but...

I may show up, I'll look for the comp room at the front desk.

Always welcome. Good to see you as always. Thanks for participating.

Thanks, Josh.